The big-time potential of small cap stocks [PODCAST]
Pinpointing winners requires a sound investment process.
Pinpointing winners requires a sound investment process.
2021 MARKET OUTLOOK
In years gone by, when manual transmission “muscle cars” were the kings of the road (picture a black, T-top Trans Am), aggressive drivers could perform what was known as the “power shift.” In this maneuver, the driver shifted gears while keeping their foot on the gas, resulting in a jolt of power that resulted in a head-snapping, heart-pounding surge for driver and passengers alike.
For the equity markets, November was a “power shift” month in many dimensions. And 2021 may be a power shift year, as well.
The stock market had one of its strongest months on record in November, but in a real power shift, performance was led by the long-lagging cyclical elements of the market, especially the small cap and value sectors.
The November “muscle car” of the market was the old value energy sector, surging 28%, while the technology powered NASDAQ continued to quietly cruise like a Tesla, up about 12%. The small cap sector also got a long-awaited jump start, with the S&P Small Cap 600 Index up 18%.
Relative to the high-powered equity market returns, the bond market looked like it was pedaling a bike. The Bloomberg Barclays U.S. Aggregate Index was up about 1% in the month, while investment grade corporate and high yield bonds clocked gains of approximately 3% and 4% respectively, still very solid returns, particularly with coupon income at such low levels.
The major fuel behind the head-snapping market returns was the impressive news regarding vaccines. With efficacy rates of 95%, there now seems to be light at the end of this long pandemic tunnel. This is a major positive development.
If a significant portion of the population can be vaccinated in a relatively short time frame, economic activity can finally begin to normalize. Significant vaccine challenges remain in terms of distribution logistics and public trust and acceptance of the vaccine. However, it seems possible that infection rates could drop dramatically by the end of the 3rd quarter of 2021.
There will literally be a political power shift on January 20, 2021 when President-Elect Biden is sworn in. However, there remains significant uncertainty regarding the power to enact legislation given what will be a razor thin senate majority for either party after the Georgia run-off elections.
Historically, the market seems to value some split in legislative power, and that seems to be how markets are factoring in the current political environment. The fate of additional fiscal support for the economy is tied up in politics. It seems evident that some form of stimulus is needed to provide a final financial bridge to future economic stability once the pandemic is in the rear-view mirror.
The economy has been surging back, boosted by the turbocharger of government transfer payments combined with high octane fuel provided by the Federal Reserve (Fed). Large corporations, with the aid of new technologies, have demonstrated an impressive ability to continue operating, if not thriving, in this challenging environment. Meanwhile, both savings and wealth levels have vaulted higher (extremely unusual in a recession), providing support to the economy.
However, the economy is not “hitting on all cylinders.” Small businesses, which account for 50% of U.S. employment, and are more service-oriented, remain extremely challenged by the pandemic environment. A swift return to business is critical for the survival of many small businesses and is also critically important for the banks and financial institutions that have loans to this segment of the economy.
The distribution of savings and wealth levels is also a “missing cylinder.” Higher savings and wealth levels are more concentrated in segments of the population that have much lower propensity to consume. The result is that these resources are more apt to be directed at the capital markets, thus pushing up financial asset prices, and not toward purchasing goods and services which bolster the broader economy.
As investors welcomed the vaccine news, they responded by beginning to pivot their portfolios toward cyclical sectors that will benefit from an ultimate normalization of economic activity.
Small-cap, mid-cap, value and emerging market stocks are the primary beneficiaries of a return to sustainable growth. These sectors had also lagged to such a degree and were trading at such depressed valuations relative to large cap growth sectors that the vaccine spark was the catalyst to dramatically change investor perception of these long lagging sectors. As confidence builds regarding the effectiveness of the vaccine programs and the durability of the economic recovery, these sectors should continue to benefit.
Meanwhile, the Fed has kept the parking brake on interest rates. It continues to purchase large quantities of U.S. Treasury and mortgage backed bonds, thus keeping interest rates in a narrow and historically low range. These low rates have been a boon to the cyclical housing and auto markets. The Fed has made it clear that this parking brake of near zero short-term rates will remain on through 2023. However, longer rates have started to slide higher, up 30 basis points since the end of March. With inflation statistics and expectations sliding modestly higher, so too will long-term bond yields. Bond returns look to be stuck in neutral at best.
After the “power shift” jolt in November, it would not be surprising if the overall markets throttled back as we close out 2020. Valuations are stretched, political uncertainty persists even after the election, and the vaccine program needs to rapidly and effectively scale up to provide relief to the country and to small businesses.
However, looking to the road ahead in 2021 – and longer – there seems to be momentum to the changes that began with the November power shift. Valuation, and now money flow, support an increased allocation (or at least a disciplined re-balance or dollar cost averaging) to the cyclical small-cap, mid-cap, value and international sectors of the equity markets.
With interest rates so low and credit spreads relatively compressed, fixed income will not provide as reliable a “seat belt” as it has in the past, but still could be the “air bag” if something more serious occurs in the markets. If additional income is a major need, specifically directing some equity allocation to higher dividend-paying common and preferred stocks, in addition to some niche areas such as selected REITS and master limited partnerships, is advised. These select niche areas provide yield of 4-10% but may not be “fixed” and are higher risk.
All information and representations herein are as of 12/15/2020, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Past performance is not necessarily indicative of future results.
Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
S&P Small Cap 600 is a market cap weighted index that represents the average performance of a group of 600 small capitalization stocks.
NASDAQ – National Association of Securities Dealers Automated Quotations – is an electronic stock exchange with more than 3,300 company listings.
Bloomberg Barclays US Aggregate Bond Index is an index measuring the performance of U.S. investment grade bonds.