Small Caps: Reaffirming My Beliefs in Alternatives

Allow me to quote myself:  “I believe that alternative investments are vastly superior to traditional investments in countless ways.”

This isn’t the first time I’ve said this, and it won’t be the last. I had the pleasure of being invited to appear on Fox Business with host Liz Claman to discuss the small cap space, specifically the Russell 2000 small cap index, with Jay Kaplan of Royce & Associates.

At the time of the interview on June 9, 2014, the Russell 2000 was trailing the S&P by 4%.

Small cap names are extremely volatile. The sector doesn’t have fundamentals and instead trades on the illusion of earnings. Many names trade at very low liquidity, and we have to anticipate in the market, there is a time when everyone will head to the door at once, creating quite a problem for small cap stocks. In traditional investments, like stocks, there is limited or no leverage, as opposed to alternatives, which use leverage.

It’s not just small caps that I have concerns about, it’s the overall market. The continued artificial suppression of interest rates by the Federal Reserve in liquidity policies have added to an appreciation of the market, and I’d guess 75% if not more of the gain in the market comes from suppression of those rates by the Fed. If and when those interest rates do start to rise, how would you, as an investor be ready to move forward?

During our discussion, Mr. Kaplan shared his beliefs that if you get into small cap stocks, you have to cherry pick your stocks. I worry about confidence in the small cap market, particularly speculation based on names alone. The confidence right now is too high and when that happens, people tend to sell, and with small cap stocks many times there is nothing there to cushion the fall. Ultimately, stock picking right now is a lost art and the great stock pickers are few and far between.

Take Warren Buffett, for example. I read he recommends his family invest 90% in a Vanguard index fund 10% in treasury bonds. He’s often considered one of the greatest stock pickers in history and if his recommendations don’t strike you as being unusual, then I don’t know what to tell you.