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Jul 07 2020

Preview: The Importance Of Quality In Small Caps

  • Jul 7, 2020

One of the signature traits of the U.S. small cap market is the prevalence of money-losing companies. Our recent tally indicates that even prior to COVID-19, 38% of small caps were reporting trailing year losses despite the widespread economic strength of 2019.

The strong market rebound in the second quarter lifted the relative return of Growth vs. Value to an all-time high by the end of June. Chart 1 reveals that the cumulative S&P 500 Growth / Value return spread hit a new record last month, surpassing the previous high reached at the end of the Tech bubble in June 2000. 

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Market perma-bulls deserve high marks for their persistence, yet, despite all that’s transpired in 2020, their case is exactly the same as six months ago: Extreme stimulus won’t “allow” a significant stock market drop, nor any further economic deterioration.

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There’s one trend that’s lasted almost as long as the bull market and economic expansion and it hasn’t definitively come to an end. The current Large Cap Leadership Cycle hit the nine-year mark in April.

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We encourage diversity of thought in our shop, but even pessimists among our ranks have a hard time making the case for a ten-year negative return for U.S. stocks, which was recently predicted by the founder of a large hedge fund.

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What can slowdown the outperformance of Growth stocks? It turns out, the answer to that persistently-unanswerable question is “Not much.” Not even a global pandemic-driven sell-off and swift rebound. From the market high in February through June 30th, Growth handily outperformed every other factor.

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Following the market bottom, the rebound across retail industries has been robust, but a divide has emerged. Consumers’ needs and behaviors have dramatically shifted as former lifestyles were uprooted. This swift change in economics has resulted in clearly-defined sets of winners and losers among retail industries.

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There has been chatter about the Fed implementing the so-called Yield Curve Control (YCC). Although the latest FOMC minutes suggest that YCC is not on the agenda for now, we believe the chance of YCC is probably much higher than the market currently anticipates.

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While investors cheer the stock market on to challenge its all-time high, new COVID-19 cases are also making daily records in the U.S. The first wave of the pandemic helped to tank the S&P 500 by nearly 30% in the course of three weeks, while the second wave, now in development, has yet to deter the raging bulls.  

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As of May 2020, domestic equity mutual funds and bond mutual funds have seen record outflow, while money market mutual funds have received record net inflow. Domestic equity and bond ETFs are also experiencing record net inflow YTD.

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Although the stock market’s VIX Volatility Index is back below 30 and continues to moderate from its surge in March, the Economy’s VIX Volatility Index is just beginning to explode! Over the last ten years, the average annualized quarterly growth in real GDP was 2.1%.

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Read this week's Major Trend. 

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Should this morning’s payroll-employment report cause stock investors to tremble? Probably not.

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From its March 23rd low to its recent high, the S&P 500 surged by almost 45%! Is the speed and size of its rally too much, too fast?

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During the first two months of the rally (and +30%) off the March lows, we noted that the usual cyclical leaders of a new bull market were underperforming on a relative basis, and there had been nothing even close to the “breadth thrust” that often accompanies an initial bull market up-leg.

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Many believe the stock market rally during this pandemic is nothing more than a sugar high orchestrated by the Federal Reserve. Liquidity trends have always been important for the financial markets, and undoubtedly, the outsized policy-push by monetary officials has played a significant role in the market’s recent success.

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No big theme this week. Just half a dozen “one-offs!”

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Turn on financial television at any random time, and you’re likely to soon hear the argument that still-high U.S. stock market valuations are “justified” by extremely-low interest rates. We’ve countered that these low U.S. rates are simply a reflection of the secular slowdown in economic and earnings growth.

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Company earnings are currently collapsing but the coming year’s consensus profit expectations are poised to lift. Several indicators that have historically been highly correlated with improvement in profit forecasts have recently turned higher and the backdrop of massive policy stimulus is supportive for upgraded outlooks.

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News that the Bureau of Labor Statistics may have undercounted the May unemployment rate by six percentage points should remind investors of the danger of taking government economic reports too seriously. Regardless of the figure, though, unemployment is no doubt near its peak for the downturn.

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Read this week's Major Trend. 

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As economic activities restart around the country, bond yields have also begun to climb. Last week, the 10-year U.S. Treasury yield rose by about 25 basis points, to its highest level since March 19th, marking only the second time since yields collapsed that they showed any sign of leaving the “sub-1%” area.

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Imagine our surprise when the bullish stock market narrative is suddenly all about money. Cynically, though, that might be because money supply and the unemployment rate are the only economic data series staging upside breakouts, and the latter doesn’t lend itself to a good narrative.

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Last December, we marveled at the disconnect between the (surging) S&P 500 and the (sagging) Boom/Bust Indicator. Just six months later, we can only scratch our heads at what the hell we were complaining about.

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Stocks (and more specifically, U.S. blue chips) did not fully (nor even approximately) discount the economic calamity. The result is that, in just over two months, the “baby bull”—if that’s what it is—has achieved what took his legendary predecessor more than eight years to accomplish: Top 25x on our Normalized P/E.

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Last month we detailed two technical shortcomings of the rally off the March 23rd market low. The stock market duly noted our critique and has issued its response.

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A brief overview of two (very different) Attractively-rated Discretionary groups that are longstanding SI portfolio holdings that have managed to maintain their “Attractiveness” throughout the tumult.

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The latest action in rates is not what would be expected during a strong stock-market rally off a bear market low, but the constantly changing nature of the stock/bond relationship should not come as a big surprise. We propose a more refined four-state definition of the stock/bond relationship.

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Late last year, we presented data showing that profitability has become more elusive for small companies despite a record-long period of economic expansion. We discussed the potential causes underlying this phenomenon.

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Asset allocation decisions are fairly straightforward for groups of profitable and growing companies that fit nicely into a discounted cash flow model, but it is more difficult to describe the valuation of groups that include unprofitable companies.

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Despite several issues of importance—national riots, an upcoming presidential election, Chinese relations, and an ongoing pandemic—the stock market is primarily focused on a single thing: the restart of U.S. and global economic activities. There is a worldwide, synchronized economic bounce afoot. Because of the unprecedented magnitude of the recent Covid-19 economic collapse (can it really get much worse?), economic news seems poised for a period of improvement.

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Read this week's Major Trend. 

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Compared to historical norms, for much of the last 30 years valuations in the U.S. stock market have remained persistently high. Only rarely has it been considered cheap and many investors have purchased stocks that, by conventional metrics, were either uncomfortably or absurdly expensive.

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The current rally is either the first upleg of a new bull market, or the second-largest bear market rally in the last 125 years. The lone development that can settle the issue is for the S&P 500 to move above its February 19th closing high of 3,386.15.

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Read this week's Major Trend.

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Things are moving fast! Attitudes and expectations are changing. On the health front. On the economic front. And, in the financial markets. Here are a few “Conjectures?”

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Raise your hand if you’ve heard this one before:

        (A)  80% of active funds underperformed their index over the past 10 years.

Now, keep your hand up if you have also heard this:

        (C)  Therefore, investors should buy passive index funds.

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Many believe it will take years to fully recover from Covid-19. Indeed, over the weekend, U.S. Federal Reserve chairman Jerome Powell suggested that although the economy will eventually recover, the process could stretch through until at least the end of next year and ultimately depends on the development of a vaccine.  

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Read this week's Major Trend. 

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