Research.LeutholdGroup

With yields on the 10-Yr. Treasury finally breaking above 1.00% last month, the consensus has quickly evolved to the view that stocks and yields can continue to rise alongside one another for a while. Small Caps have shown a decisive performance edge during the recent episodes.

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The recent months’ surge in Small Caps has been historic, and the Russell 2000 continues to register ridiculously “overbought” readings on many technical oscillators. In the short-term, that might be a cause for caution on the overall market. However (and perhaps counter-intuitively), this extreme strength cements our view that a long-term leadership cycle in Small Caps is underway. 

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Often, what market pundits like to pass off as bold, contrarian forecasts are merely rationalizations and extrapolations of trends that have already been in place for some time.

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In the extreme case where one possesses no other information beyond last year’s total returns, the best single-asset strategy has been to buy the second-best performer (the “Bridesmaid”) and hold it for the next twelve months in hopes that the prior year’s momentum will carry it through. That approach has beaten the S&P 500 by 3.7% annualized over the past 48 years. 

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Cap-weighted valuations for the S&P 500 and S&P Industrials are homing in on the all-time records seen in the first quarter of 2000. We’ll confess that after those valuations collapsed in the years that followed, we thought we’d never see them again in our lifetime—let alone a mere generation later. 

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Driven by massive government stimulus, an imminent vaccine rollout, and the expectation of record earnings in 2021, investors seem to be on the verge of embracing a move away from Large Cap Growth stocks in earnest. The leading candidates offered as broad-based alternatives to Large Growth (LG) include Value, Small Caps, and Emerging Markets.

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Knee-jerk contrarians are already claiming the stampede in Small Cap stocks is “too consensus” to continue in the near term. We couldn’t disagree more. In fact, we are very confident that a new multi-year Small Cap leadership cycle has kicked off.

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This study examines Value, Small Cap, and Emerging Markets to see if they do, in fact, behave in a correlated manner when viewed as alternatives to Large Growth. The goal is to determine whether this trio of rotational favorites can be considered as broadly-equivalent replacements for LG.

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Perusing current equity-investment possibilities highlights a diverse set of choices. Focusing on only two primary attributes—relative price and relative earnings—illustrates considerable diversity among the major investment styles.

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Our Very Long Term (VLT) Momentum algorithm has been a very good “confirmatory” market tool over the years, especially at the onset of a new cyclical bull market. But VLT has proven to be of little to no value in navigating this year’s gyrations. VLT’s latest flip-flops reinforce our view that the market leaderboard is set to be rearranged.

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The big jump in Small Caps over the last two weeks has entirely reversed the segment’s summer underperformance and has technicians feverish about another “breath thrust.” Technically, it’s impressive, but we are more intrigued by the fundamental potential for continued Small Cap (and Mid Cap) outperformance.

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Mid and Small Cap stocks underperformed in 2018 and 2019. However, after the collapse of February and March, these “SMID” Caps have largely kept pace with the torrid rebound in the blue chips. Today’s valuations are priming the SMIDs for a similar “decoupling” in the years ahead, like that following Y2K.

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One of the signature traits of the U.S. small cap market is the prevalence of money losing companies. A recent tally indicated that prior to Covid, 38% of small caps were reporting trailing year losses despite the widespread economic strength of 2019.

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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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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.

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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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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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Small Caps lagged during the bounce off the March lows before a late-April spurt briefly pulled them ahead of the S&P 500. Still, considering that Russell 2000 losses were so much steeper than the S&P 500’s (-43% versus -33%), we would have expected something better.

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Through last night’s close, the S&P 500 had gained 25.0% in exactly one month. Impressive, but a bit superficial. Anyone running active equity portfolios recognizes the breadth of this move has been unusually narrow.

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A composite measure of Mid Caps and Small Caps are at bottom-decile valuations relative to their 26-year histories. From a shorter-term viewpoint, though, we find it scary that valuations are so low just a single month into the recession.

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We were fooled on Small Caps, and it’s been a “multi-factor” catastrophe.

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As deep as the losses in the DJIA and S&P 500 have been, most professional investors recognize that those averages have masked the extent of the damage suffered by most stocks.

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The underperformance of Mid and Small Caps in the last few years has taken valuations from top-decile readings (and, indeed, a few all-time records) just 25 months ago, down to the middle—and even lower reaches—of their 30-year valuation boundaries.

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December’s Of Special Interest provided a recap of our Asset Allocation team’s view of small cap equities, suggesting that small caps had underperformed and reached a valuation discount that made them an interesting contrarian value proposition. Several clients responded with follow-up questions, wondering if the discount valuation of small caps was offset by their typically weaker business models.

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In response to client queries, we extended our research of small cap equities from last month. One angle we pursued was the relationship between small caps, quality, and business risk. The full report will be released mid-month.

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Leuthold’s research team has recently flagged a number of items that suggest it may be time to consider small cap stocks. This asset class has been showing signs of life and the decision to overweight small caps is starting to seem relevant – and perhaps nicely profitable - again.

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For valuation work, we’ve traditionally favored the 1,200 company Leuthold Small Cap universe over the S&P SmallCap 600 because we get almost a full additional decade of perspective. But figures for the latter shed extra light on just how significant the revaluation in Small Caps has been.

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Our call for improved relative performance in Small Caps received another boost in November, when VLT Momentum for the S&P SmallCap 600 confirmed the prior month’s “low-risk” BUY signal on the Russell 2000.

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A way to gain perspective on the present is by trying to view it from the future. Ask yourself, “What are the signs of impending decline, now ignored by investors, that will one day be memorialized by the same investors as the most obvious in retrospect?”   

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At October’s close, a long-term BUY signal was triggered on the Russell 2000. The fact that some market segments are triggering “oversold BUYS” when blue chips are at record highs speaks volumes about the internal disparities that have developed during the last few years. The Russell BUY signal is not inconsistent with our belief that the action since the January 2018 peak remains part of a lengthy cyclical topping process.

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Small Caps came tantalizingly close to activating a major VLT BUY signal in September, with the Russell 2000 closing less than a half percent below the trigger level. A new bull signal from this indicator wouldn’t “fit” into our market and economic narrative, but we won’t sweep it under the rug if it occurs.

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Despite a historic economic expansion during the past decade, there is an ever-increasing number of companies that are finding profitability has become harder to achieve.

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The Russell 2000 is the most important major index on the cusp of a new BUY signal. Our best guess is that Small Caps will still trend lower for now, creating a buying opportunity in the months ahead.

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Earnings results for the second quarter have so far "beaten" expectations (as they always seem to), but that hasn’t changed the calculus for Small Cap companies. About one-third of them have negative earnings over the last twelve months.

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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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