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May 06 2021

Research Preview: Global Small Caps

  • May 6, 2021

U.S. small caps have posted blockbuster price gains coming off the pandemic bear-market low in March 2020. We were curious to see how international small caps have performed since then, and launched this project to learn how this asset class has recently behaved in other regions.

After significantly decreasing in the previous decade, employee compensation of U.S. corporations, as a percent of nominal GDP, has risen slowly but steadily since 2010. That is, rising labor costs have proved to be a modest but growing challenge for labor-intensive industries.

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It’s been a tough week for investors. Although the Federal Reserve has been trying to prepare us for a “transitory” inflation spike, a single-month surge to a 26-year high in the core, annual consumer-price inflation rate has challenged the Fed’s narrative. After all, many thought it was only a matter of time before the overuse and abuse of monetary and fiscal policies would come home to roost. 

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The CPI numbers blew past market expectations. Equity investors might feel it’s too hot, as higher inflation has historically been associated with lower equity valuations.

 

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Our ongoing research into the relative performance of active vs. passive styles reveals that market conditions play a significant role in the active/passive return cycle. We identified a set of metrics that describe the market conditions we believe influence which management style is more likely to outperform. This note updates our data through March 2021.

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Most bull markets of the last 40 years commenced when company fundamentals and earnings were still declining from a recession. Because of that, valuations often worsen considerably during a fresh bull run as the stock market surges despite continued earnings weakness.

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Investors turn to gold when they fear inflation. Therefore, historically, the price of gold has often significantly outpaced other commodity prices “before” the rate of consumer inflation accelerates.

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Navigating the investment landscape over the past year has been a journey full of surprises. No data other than “earnings surprises” can better demonstrate how unpredictable companies’ financial performance has become. 

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Valuations aren’t known as effective timing tools, but they can certainly help one decide when an attempt at timing may be appropriate. And if that time isn’t now, then when?

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April ISM readings, both for Manufacturing and Services, were hot across the board. That’s good news for a still-recovering Main Street, but it manifested in ways that have frequently caused problems for a famous Street located in Lower Manhattan.

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Housing-related groups have catapulted to the very top of our rankings. Several of these are among the top-ten performers of our 120-group universe. Despite the strong returns for these industries, our GS Scores indicate that this theme has even more room to run.

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We understand the various rationale for the upward shift in equity valuations seen over the last quarter century or so. Unfortunately, wiping away all market history prior to 1995 does not make stock valuations appear significantly less inflated. 

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The Group Selection (GS) Scores are off to a fantastic start in 2021, and the Select Industries strategy, which takes its cues from the Attractive range, has taken full advantage.

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We don’t make much use of “Forward” EPS for the S&P 500 because analyst forecasts have tended to be hopelessly optimistic. But if their short-term projections are on target, when numbers for the current quarter are reported, 12-month trailing GAAP EPS will exceed the $139.47 pre-COVID peak.

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Economic numbers were red hot in April but a funny thing happened when the awesome data rolled in—bond yields actually went lower. Expectations have trended upward, and “whisper” numbers have set the bars even higher.

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Read this week's Major Trend. 

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As the economy recovers from its COVID bust, cyclical stocks have enjoyed a nice run. Based on a geo-weighted index of the primary, economically sensitive sectors comprising the S&P 500 Index—Materials, Industrials, Consumer Discretionary, and Financials—cyclicals have outpaced by +4% this year and close to +10% over the last year, but it has not been uneventful.

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The current Bull Market has so far exhibited an attractive self-sustaining character. The accompanying charts highlight the relative performance of eight distinct investment attributes: Value, Growth, Cyclical, Price Momentum, High Quality, Small Cap, EM, and High Beta. Although each of these has had its day in the sun, no single investment attribute has persistently dominated since the Bull Market began after the March 23, 2020, Bear Market low.

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Read this week's Major Trend. 

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A sustained period of significant inflation is probably the biggest risk facing investors. Signs abound that inflationary pressure is building. The S&P GSCI Commodity Price Index has more than doubled from its lows last April, bond-market breakeven rates have surged this past year (i.e., illustrating bond-investors’ inflation expectations), and both manufacturing and service-sector companies report some of the strongest selling-price flexibility on record.

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Earnings releases (ER) are normally accompanied by large stock-price movements, either to the upside or downside.

Here, we computed the percentage of companies that registered a large move in their stock price on their ER day in the trailing three-month window (500 basis points up OR down). In order to normalize for non ER-day volatility, we computed the percentage of all companies that registered a significant price move on any day during the same period. The difference between the two is shown in Chart 1.

 

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The onset of the COVID-19 pandemic in early 2020 brought a sudden halt to social gatherings, crowd events, and even personal contacts. Experiential business models were hardest hit by forced closures and lockdowns; cruise ships were forbidden to sail, restaurants and theme parks were closed, and air travel and hotel occupancy dwindled, all in an attempt to minimize personal interactions. The stocks of leisure services companies took a beating in March 2020, with Chart 1 documenting the virus’ impact on 34 large and midcap stocks representing this theme.

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Last week, a unique character of the contemporary, economic recovery was highlighted. Blowout numbers were widely anticipated for the retail sales report on Thursday and expectations were huge. Nonetheless, when the early-morning report was released, the actual numbers were nearly double the elevated forecasts.

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In the latest Green Book, we noted that Producer Price Inflation does not usually become a challenge for the stock market until its annual rate breaks above 4.0%. The day that comment was published, the year-over-year gain in the March PPI for Finished Goods spiked to 6.0%, thanks mostly to the well-celebrated COVID-19 anniversary-effect. 

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After steadily rising since last fall, small-cap stocks have recently staggered. Although the Russell 2000 is off by only about 5.5% from its record high in mid-March, it has underperformed the S&P 500 by almost 10%.

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The CPI numbers are a tad better than market expectations. Expectations for higher inflation are already quite high and that means simply meeting expectations might not be enough.

 

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Read this week's Major Trend. 

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Just a few unrelated thoughts to ponder this afternoon…

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Not surprisingly, confidence among the highest earners is generally more positive than that of low earners. However, the extent of this “confidence-differential” will vary over an economic cycle. The confidence-differential compares the results of the highest 33% of earners to that of the lowest 33% of earners, based on the University of Michigan’s Consumer Sentiment Index.

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The price action in the DXY Index over the last year shows an uncanny resemblance to the 2017-18 period, both in duration and magnitude. Overall, we believe the dollar could strengthen in the near term, but the longer-term bearish trend remains intact.

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Historically, companies that have grown their equity share base over the previous year are apt to underperform the broad market in the ensuing months; those that had reduced shares outstanding tend to outperform. However, the opposite happened over the course of the last year. Here we explore the underlying details to see what contributed to this result.

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This month we focus on the valuations of the MSCI USA Index—which is nearly identical to the S&P 500. This is worth following mainly because the folks at MSCI are kind enough to provide us with much longer-term histories of Cash Flow and Book Value Per Share.

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We launched a revamped version of our Major Trend Index. The objective of the new methodology is to increase the flexibility, and even the subjectivity of the MTI. This approach recognizes the “subjective reality,” without forcing us into the tedium of re-weighting sub-factors if they become more or less critical as market dynamics evolve.

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The stock market’s technical backdrop remains pretty hard to assail, as evidenced by the current +4 reading on the revamped MTI’s Technical category. But there are a few short-term cracks that bear watching. 

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Massive net-cash outflow from equity mutual funds (MFs) shows no sign of slowing, even as equity markets notch new record highs. Combined MF net outflow that focuses on domestic and foreign equities tallied a remarkable $646 billion in 2020—practically doubling the previous outflow record set in 2019.

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A strong argument can be made that experiential consumer services was the economic sector hardest hit by the pandemic lockdown. Cruise ships were forbidden to sail, restaurants and theme parks were closed, and air travel and hotel occupancy dwindled—all in an attempt to minimize personal/public interaction. The stocks of experiential companies took a beating in March 2020.

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Read this week's Major Trend

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The seventh-longest persistent period of leadership by a single U.S. stock-market sector since 1928 came to an end in March. What does this imply, if anything, about the future of the contemporary bull market?

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The U.S. dollar declined last year, but, so far, in 2021, the dollar has been rising. U.S. bond yields have surged far more than foreign yields lately, making dollar investments more attractive. However, U.S. inflation is definitely accelerating, which is never good for the U.S. currency.

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