Research.LeutholdGroup

Small Caps typically underperform during a bull market’s final phase, and our findings with respect to the Output Gap aid our understanding of that phenomenon.

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The 1999 leadership parallels we discussed in the latest Green Book remain intact—U.S. over foreign, Growth over Value, and Large over Small. Small Caps have given up most of the “beta bounce” enjoyed in the first two months off the December low, with one Small Cap measure—the Russell Microcap Index (the bottom 1000 of the Russell 2000)—undercutting last year’s relative strength low and those of 2011 and 2016.

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For much of this decade, we had an allocation preference for Large Caps over Small Caps because of the considerable P/E premium commanded by the latter.

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With three quarters of a sharply lower corporate tax rate on the books, the median four-quarter trailing profit margin for both the S&P 500 and S&P MidCap 400 jumped to all-time records in the third quarter.

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While this year’s liquidity squeeze has yet to exact the toll we ultimately expect on the U.S. stock mar-ket, it has certainly contributed to a sharp compression in P/E multiples.

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It’s difficult to knock a stock market in which Small Caps and major breadth measures are making frequent new highs, however, there are performance anomalies that suggest liquidity is no longer sufficient to “float all boats.” Recent underperformance of the Equal Weighted S&P 500 is a case in point, at the same time, the current dichotomy in market breadth pales in comparison to the 1999-2000 episode.

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Today’s market is barbelled regarding company size, with the mega-cap Tech stocks and the S&P 600 Small Cap index both outperforming the middle of the S&P 500.

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Tomorrow is the Minnesota season-opener for muskies, but the fanatics who chase them are likely disappointed that it comes a few days after an event that’s known to trigger these beasts: the full moon. The screenshot is from our $9.95 “iSolunar” iPhone app, and shows that Saturday merits only a “three fish” day (out of a possible “four fish”)—based on the moon’s fading illumination. 

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Last week’s piece challenged the now popular view that new highs for the Russell 2000 are a decisively bullish factor for the stock market in the near term. To our surprise, we found that market returns during periods of well-defined Small Cap leadership are significantly lower than when Smalls are laggards.

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The Russell 2000 closed above its January 26th high on Wednesday, and well beforehand bulls had seized upon the secondary stocks’ leadership as evidence that all is right again with both the U.S. economy and stock market...

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If one manipulates the data correctly, one can make the size effect—whereby Small Caps earn excess returns over the long pull—look instead like a beta effect.

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Following 2016 underperformance, High Quality stocks eked out an advantage over Low Quality stocks to begin 2017 (+5.3% versus +2.1%, respectively). Yet, the “Junk Rally” trend seems difficult to reverse.

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We’ve seen several pundits’ analyses of the “Sell In May” phenomenon of late, but none of them has addressed the most salient feature of this anomaly, which is that it’s historically been a predominantly Small Cap phenomenon.

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While the Russell 2000 loss during the 2015-16 correction was almost double that of the S&P 500, the decline did not fully erase the P/E premium Small Caps have enjoyed since the middle of last decade. The premium might need to be entirely erased before a multi-year Small Cap leadership cycle can begin.

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The S&P 500 has gained about 5% on the year, respectable but hardly consistent with the “melt up” scenario we thought might occur.

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Fed tapering of its QE3 asset purchase program ended two years ago this month, yet we don’t believe this episode has received appropriate recognition for the role it’s played in the relatively flat stock market environment that’s followed the onset of tapering in January 2014.

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While the most inflated domestic-valuation readings are found in the Large Cap realm, the market rebound has driven the median 12-month trailing P/E in our Small Cap universe to 22.5x (Chart 1)—less than a point away from the June 2015 all-time high of 23.3x.

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There was a major cyclical BUY signal (VLT Momentum) for the S&P 500 in late-May, and as of July’s close, that bullish development was reinforced by a new VLT BUY signal on the Russell 2000.

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We’ve boosted equity exposure twice in the past several weeks, fully cognizant that it’s not a “textbook” time to do so.

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Small Cap valuations may look better on a relative price-to-book basis, but we still believe their Normalized P/E ratios will suffer further compression before Small Caps reclaim the leadership baton.

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After spending two months in discount territory, in March the Ratio of Ratios headed closer to its historical median premium of 4%.

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When the Fed surreptitiously began to tighten as we believe (via tapering), in January 2014, history suggested that Consumer Discretionary and Small Caps would be the most likely initial market victims (at least from a relative perspective).

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This bull market has appeared to be on shaky technical ground before, only for concerns to be swept aside. This time, we think it’s different.

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Our current view is the lift-off will be December or later. Assuming inflation will pick up and the Fed hikes the rate by the end of 2015, stocks will perform relatively well, with international stocks a better bet than U.S. stocks.

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Small Caps lagged the S&P 500 by almost ten percentage points in 2014, but their underperformance streak technically dates back to April 2011. Nonetheless, their cumulative, 45-month underperformance in relation to the S&P 500 (now about –18%) is still modest enough that any mention of the current “Large Cap Leadership Cycle” is bound to draw a few head scratches.

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The dollar’s moonshot in recent months has resuscitated a stock market leadership argument we haven’t heard for a long time.

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The recent strength in the dollar coincided with a spike in volatility and weakness in risky assets, but the relationship over the last couple years has been tenuous at best.

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With the Fed mulling over a rate increase, investors may have already started to avoid companies with excess leverage. Unfortunately, Small Caps, on average, are in this camp.

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July’s Russell 2000 -6% rout finally deflated some of the Small Cap valuation premium we’ve been grousing about in recent years.

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Small Caps have staged a nice rebound in the last several weeks. On July 3rd, the Russell 2000 rose to within a fraction of an index point of its March 4th all-time high. But on a relative strength basis, the bounce has been pretty muted.

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Based on the historical percentages, the bull market should have a minimum of four to six months of life left. But the market has a way of throwing sand in the gears when you think you’ve begun to understand its internal mechanics.

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Small Cap Premium Bounces Back To 23%

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Small Caps are selling at a 20% valuation premium relative to Large Caps (23% last month), using non-normalized trailing operating earnings.

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Small Cap Premium Continues Upward To 23%. Large Caps Lead On The Downside In January

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Small Caps are close enough to a new relative strength high that it’s possible a final revision might be necessary before the Small Cap tide flows out.

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Small Cap Premium Continues Upward To 21%. The red-hot equity market of 2013 was especially good for Small Caps with a +38.8% total return.

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The investment leadership of a given year has historically had better-than-even odds of outperforming in the following year at both the asset class and equity sector levels.

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Gains will likely be modest, and secondary stocks could finish the year flat-to-down. The year will likely be marred by a moderate to severe mid-year correction, and Small Caps could easily suffer a 20% hit during that swoon.

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Small Caps are selling at a 20% valuation premium relative to Large Caps, using non-normalized trailing operating earnings.

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Momentum and Value worked in 2013. Materials and Financials were the easiest sectors to exploit; Discretionary and Tech the most difficult. Momentum works in December; Value and Small Caps at the start of the year.

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