Business Loans, Growth, Small Cap Bet

Business Loans, Growth, Small Cap Bet

February 1, 2005

Business Loans Have Turned the Corner.GIF

Why growth will be stronger in 2005 than people think.

Why I have a bet on small cap stocks

Banks loaned businesses minus $230B between November 2000 and May 2004. That means banks collected about $1 billion more from businesses than they loaned to businesses ever week for three and one half years. As you can see in the chart, and at the FRBSL website, this was the sharpest contraction of bank credit since the Great Depression.

I wrote an op-ed about this subject in November, 2001 warning that non-price credit rationing would hit small businesses very hard, that small businesses make up more than half of GDP and 3 out of every 4 jobs. This was the reason we had a jobless recovery for so long.

Last May banks opened their doors to business borrowers again, as you can see in the chart. This corresponded to the end of the refi boom. Since then business loans have increased by about $40 billion. To date, this increase in lending has been restricted to small banks—large banks are too busy being investment banks to bother with business loans.

Doesn’t take a genius to figure out what that means for growth. Both GDP and job growth will be surprisingly strong in 2005, just as they were surprisingly weak in 2001-2003. Profits will be stronger than people think too; double digits for the year.

This explains why I hold a bet on small cap stocks today. As you know, I manage my equity portfolio by tracking storm systems—situations where an abrupt policy change has produced an after-tax yield differential. Yield gaps attract the attention of arbitrageurs. If you put your bet down early they will give you a free ride as they create capital gains by driving returns into line.

Large companies don’t borrow money from banks; small ones do. This story means small companies are enjoying a sharp drop in their effective cost of capital. They will grow faster; faster than before and faster than big companies. I think small caps will outperform the overall market in 2005.

How to place a bet? There is an exchange traded fund (ETF) that owns the S&P small cap index. It’s ticker is IJR.

John Rutledge

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