Forget the Fed, Bank Loans are Back. Buy Small Caps

Forget the Fed, Bank Loans are Back. Buy Small Caps

December 14, 2004

The Fed raised the Fed funds rate one-quarter percent again today, which took the inflation worriers by surprise; pushing 10 year Treasury yields 19 basis points lower, and turned my screen completely green as stock prices responded. The real isue is business loans, and they are heading up.

This is one of those stories you can use over and over again. It seems like investors talk themselves into believing inflation is rising every six months. When they do, take their bet. This economy is driven by productivity growth, which means lower costs and prices and rising profits. Inflation is not a problem.

Most important point about monetary policy is not the Fed’s rate move today. It is the fact that banks, which had shut their doors to business lenders from late 2000 til this May, have opened for business loans again. Loans were down $230 billion from December, 2000 to May, 2004, the sharpest decline since the Great Depression. Since then business loans have increased by about $30B, as you can see below.


It’s small banks, not the big ones, that are lending as you can see in the chart below. That’s very important for growth and hiring in small companies, which make up more than 50% of GDP and 75% of new jobs. This economy is going to grow by 4% or more next year.


The return of banks to business lending creates an interesting opportunity in the market. Large companies never borrow money from banks; small companies only borrow money from banks. This should make small cap stocks outperform large caps as small companies respond to the sharp implicit drop in their cost of capital as banks become more friendly. They have increased by nearly 20% since their August lows.

Collateral evidence in the middle market buyout business, where lenders are lining up for meetings and sending huge boxes of candy to private equity sponsors again (and it’s about time; I was getting hungry.) Today’s market, with small caps (IJR) up big relative to large caps (SPY), is an illustration. And you are going to hear a lot of we love small business talk this week from the White House meetings this week. I am staying long small cap stocks.


John Rutledge

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