Smaller caps could be good defensive mechanism tool

The history of public trading of company stocks goes back to the 17th century when in 1602 the Dutch East India Company listed its shares on the Amsterdam Stock Exchange. A number of developments took place afterwards, both documented and unwritten.

However, at the turn of the 20th Century, the United States began to sprinkle the seeds of its global hegemony. Key among them was the exchange platforms for securities issued by corporations.

As the American economy transformed into a humdinger, especially after the Second World War, a surge in public trading of corporation stocks elevated the status of its financial markets.

Although US stocks markets are not as old as Euronext Amsterdam or London Stock Exchange, they remain the largest and command significant depth and sophistication, largely driven by domestic institutional participation-led by pension funds. The American stock markets is an important component of its economy. And because the economy is built on credit-led spending, interest rates is its lifeblood.

Indeed, the US stock markets are a vital aspect of interest rate decision(s) by its central bank—the Federal Reserve (or the Fed). Because of its elevated role and participants’ sophistication, it has, over time, attracted significant amount of cheerleading.

The US media traditionally topped the cheerleading. However, they have now been disrupted by President Trump’s glossy tweets praising every new market top (largely crediting every top to himself).

The cheerleading has also attracted a lot of witchcraft—which entail creation of eccentric stock market indicators.

The witchcraft stems from the fact the US stock markets have tended to amplify a lot of the global economic cycles, such as the Great depression, the dot.com bubble or the 2008 global financial crisis.

Some of the eccentric stock market indicators developed by its followers, which primarily measured the overall morale of the investing population, are almost ludicrous.

One of them is women's hemlines. As hemlines rise, so does the stock market (and vice versa applies).

Consider the roaring 1920s when women wore short flapper skirts and a stock market rise followed. When the market crashed during the great depression, long, modest skirts followed. So the hemline index implies that as people become more exuberant, stock prices rise and clothing becomes more daring and as society becomes pessimistic, people become more conservative with their clothing and investment choices.

There was also Lipstick sales. When the market is down, women buy cheaper brands. And golf? There was an observation around the number of golf balls left at the driving range.

Apparently, golfers never left golf balls when the market was in declining mode. Moral of the story?

Emerging markets worries that have topped investors’ minds this year, largely gravitate around public finances and external positions (Argentina and Turkey being the classical examples).

This has triggered portfolio outflows. In Kenya, gross portfolio outflows have amounted to slightly over Sh100 billion since the year began. Such a melee tends to hit the large stocks that command strong foreign visibility, often with disastrous consequences.

The NSE-20 share index, which houses most of the large cap stocks, has declined by 25 percent year-to-date. On the flipside, a price-index I constructed for a basket of 43 small cap stocks (with market capitalisation of under Sh20 billion) have only lost under one percent in the same period, proving quite defensive enough.

This then calls for investors to seriously consider the small caps stocks as part of their defensive strategies. But broadly, to add to the body of stock market eccentricity, emerging market melees and the attendant portfolio outflows, on a significant scale, is probably a cue to diversify into small caps. Sometimes smaller is better.