The Bullish Case for China and US Small Cap – Tom Lee

The ever-bullish Tom Lee from Fundstrat made his appearance on The Compound Show this morning. He brings along some interesting data charts and some nuggets.

The hosts were interested to hear what he thinks about hedge fund manager David Tepper’s bomb on China, macro-economics and small caps.

Before we get into it, if you like the content put out, you can get it and more via my Telegram channels:

David Tepper’s “Buy Everything” Call on China

David Tepper’s interview here.

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14 min: Fundstrat will treat what is happening in China as a real move.

• Technically, Mark Newton at Fundstrat sees many of the China companies approaching multi-year highs (KWEB and FXI ETFs).
• China’s government is trying to restore confidence, and equity is one channel.
• This is a little like the situation what ECB President Mario Draghi said in July 2012 about “whatever it takes” | Google Search here
• Imagine this in an environment where the US is also dovish.

Short interest in the FXI has been high and we are finally seeing a high in inflows into the ETF.

Macro Backdrop

Most people are looking at the macro backdrop and think this is late into a bull market but Tom says the data looks more like early cycle.

There is a huge gap between the different perception.

Housing, durable goods and transport have been in a recession. Most think that these are indicators of a recession and more to come but Tom Lee thinks the Fed turning dovish may change things.

Private investment as a percentage of GDP is 25% and we never been late-cycle until this is beyond 27%.

This slide shows interest rate loan products for various segments of the economy:

This slide shows how much these rates are likely to drop when the Fed cuts the rates. Tom thinks that the 30-year Mortgage fixed rate could drop below 5% based on past data.

The first signs we should look at that this gets worked into the economy is housing activity.

This chart compares the components that make up the CPI in the US before and after the pandemic:

The black line shows the percentage of CPI (equal-weighted) that is less than the 10-year average from 1999 to 2019 (20 years). The higher the better.

The red line shows the 20-year average.

We were below that for quite a while but 55% of the CPI components are back to pre-pandemic levels.

Since this is equal-weighted, it does not distort (auto insurance and housing currently distorting) compared to the actual CPI where certain components are weighted more.

It is not a Hard or Soft landing. There are many No-landings

This chart shows that when the Fed cuts and there is no recession, it is hugely positive for the market:

Stocks have never been lower if we look at the three and six-month time frame.

Critics would point out there there was never a soft-landing but there are many instances of no landing.

Utility Companies are Ripping

This chart from Bank of America shows the record inflows into utilities this week:

If we list the year-to-date return of all the stocks in S&P 500, three utilities companies (VST, CEG seen here) are among the top performers:

Utilities are currently AI AND interest rates plays.

The Tail Winds of Small Caps

In 2022, the Fed basically signalled to the business world that there is a financial hurricane coming and businesses got cautious. Those with cash weathered well and the small caps, more reliant on credit got destroyed.

Since they tell them to prepare, many companies may have treated as if they are in recession and react accordingly by deferring capital expenditure (usually about 5%) and firing people. Mergers may have been put on hold.

With more boardroom confidence, this may be expansionary.

Small Caps may be the biggest beneficiary because they been the most whacked.

The median Russell 2000 PE of the companies is 10.5 times. It would be 12 times if we consider only the profitable Russell 2000 companies. The companies in the S&P 500 is close to 18 times currently.

The small caps can have room to grow 80% just by PE catching up.

If we include that earnings is growing, and that small caps usually trade at a premium, Tom thinks it is possible for the small caps to catch up with the large caps.

This chart overlays the 5-year compounded average growth (CAGR) of the S&P 500 and Russell 2000 (every point on the top chart is 5-years return) and the Russell 2000 outperformance over the S&P 500 in the bottom chart:

Since 1984, there were two large periods where the Russell 2000 underperform the large caps so this is not too surprising.

Tom thinks that unless you have a valid reason that small caps are worse companies than in the past, and it justifies a valuation difference of 8 time (see 10.5 times PE vs 18 times PE), then this underperformance should narrow.

Small Caps are as cheap as in 2002, which is the start of a 12-year small cap outperformance based on median PE and relative price-to-book.

This chart breaks down the S&P 500 and the Russell 2000 based on their components:

Fundstrat highlighted in red the sectors that are cost of capital sensitive.

Since small caps have a higher percentage to cost of capital-sensitive sectors, they can rip or die when cost of capital changes.

You would also have to be bullish to biotech if you are into small caps.

Fundstrat did a correlation study and determine that if small caps is a sector, they would be second to consumer discretionary in terms of correlation to China.

CCC-rated bonds (speculative grade) and BB-rated bonds (barely investment grade) credit spreads are correlated to the Russell 2000.

Small Caps is basically risky and there is a risk premium there.

This chart breaks down the FY 2025 EPS Growth (over FY 2024 EPS), with the help of data from Factset, into S&P 500, Russell 2000 that is EPS positive, and including the not positive ones:

The bottom half breaks the three indices down to five buckets based on their EPS growth (FY2025 EPS vs FY2024).

Aside from the lowest EPS growth bucket, the Russell 2000 shows that the forecasted EPS growth is much higher than the S&P 500.

The 20% fastest growing Russell 2000 companies are growing at 100%.

Small caps are just growing faster in revenue and earnings-wise. Of course, the market may be pricing in this positive EPS growth.

Tom provides EPS surprises that may not be priced in (and not reflected in the chart above):

• Fed easing which means the cost of money is dropping.
• China may be turning, which helps Europe, which may lead to spending surprises.
• Labor market softening which means wage pressures are easing.

Tom thinks that the small caps are trading at where it is firstly due to the money flow, as there isn’t a lot of appetite for risk. Investors tend to prefer price momentum and that is where capital tends to flow.

Secondly, the percentage of companies that don’t make money is 40%, of which the majority are biotech companies. This distorts the overall Russell 2000 EPS number.

The IJR, or the Core S&P 600 ETF, is a good proxy for the profitable small caps.

This chart shows the sub-industries that are more correlated to the FTSE China 50 ETF:

And a lot of them are cyclical, and the small caps have more of these.

If China goes back to a 52-week high (not an all-time high), many of these cyclicals would benefit.

The Larger Demographic Picture and Secular Market Trends.

Tom Lee brings this interesting research where they overlay the demographics of US population and the stock market (Dow Jones Industrial Average):

What we notice is that the major market declines tend to coincide with periods where various generation reaches the peak population.

Fundstrat has a chart that shows the 10-year rolling relative inflation follows the generation cohort. The generation cohort also correlates to the S&P 500 returns.

S&P 500 returns tend to accelerate towards the peak.

Semiconductor

This chart shows the wave of labor shortages (positive) and labor excesses (negative), overlayed with the tech sectors:

Whenever there is a period of labor shortages, tech goes parabolic.

Global labor shortages are higher and US is the main supplier of technology.

Watch the Video

You can catch Tom Lee’s appearance on The Compound show here

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