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Janet Yellen's surprising warning about small caps

Fed chief says U.S. economy still needs help 02:22

Federal Reserve Chairman Janet Yellen delivered a largely-as-expected performance in front of Congress Wednesday. But she did have a couple of surprises.

She reiterated the Fed's view that the economy's abysmal 0.1 percent annualized GDP growth rate in the first quarter (on track to be downwardly revised to -0.6 percent according to Macroeconomic Advisors) was largely due to severe winter weather. She repeated that the job market remains soft enough and that inflation remains low enough to justify an ongoing easy monetary policy stance.

And she deflected criticism that the Fed's cheap-money policies have contributed to inequalities of wealth and income. However, an opinion piece in Wednesday's Wall Street Journal by Allan Meltzer, a Fed historian and Carnegie Mellon economist, has brought this issue to the forefront again. Meltzer warned that a prolonged period of ultralow interest rates has inflated asset prices (benefiting the rich) while sowing the seeds of painful inflation (which regular families will bear).

Incipient price pressure can already be seen in food prices, which are on track to rise nearly 4 percent this year, according to the U.S. Department of Agriculture. Meltzer believes this is just the start of an inflationary push that will broaden to other areas of the economy.

But the big surprise from Yellen was her comment that small-cap stocks were showing pockets of possible overvaluation. And she said it in a casual, offhand way that brought to mind the infamous "six months" comment she made at her first post-policy announcement press conference -- a comment that rattled markets by bringing forward the timing of the Fed's first short-term interest rate hike.

It also brings to mind comments made in mid-February by Federal Reserve Governor Daniel Tarullo that small tech stock valuations appeared stretched. Not long after, the group came under selling pressure that still persists, with Twitter's (TWTR) tumble being just one example.

The reason Yellen's comments could be so damaging is that small-cap stocks are already vulnerable: The Russell 2000 small stock index lost its 200-day moving average on Tuesday for the first time since 2012, ending an 18-month uptrend.


Moreover, the performance gap between small stocks and the overall market has grown to a worrisome level. According to Jason Goepfert of SentimenTrader, Tuesday marked only the third time in 35 years of market history that the NYSE Composite was sitting at a 52-week high one day, and the next day the Russell 2000 fell below both its 50- and 200-day moving averages.

The other two dates were March 12, 1999, and November 1, 2007. Not exactly favorable dates to be buying stocks, as new bear markets materialized shortly thereafter.

For now, I continue to recommend investors maintain a cautious stance focusing on areas such as U.S. Treasury bonds, which are benefiting from a recent decline in long-term interest rates -- possibly driven by bond market concerns about the economy's health. Examples include the leveraged Direxion 3x Treasury Bond Bull (TMF), which is up nearly 12 percent since I added it to my Edge Letter Sample Portfolio back in February.

More aggressive investors can make profits from the selling pressure that's plaguing smaller stocks. Put option positions I've recommended to Edge Pro clients against Coach (COH) and Lululemon (LULU) are up 407 percent and 240 percent, respectively.

Disclosure: Anthony has recommended TMF and puts against COH and LULU to his clients.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.

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