The big-time potential of small cap stocks [PODCAST]
Pinpointing winners requires a sound investment process.
Pinpointing winners requires a sound investment process.
Last week the equity market showed its first signs of faltering since the sharp rally in risk assets began at the end of March. However, it has been an amazing recovery given how “sick” the global markets appeared after global quarantine measures were put in place.
Since the low on March 23, the S&P 500, NASDAQ and the Russell 2000 are all up over 35%. Even the long lagging EAFE International Equity Index is up approximately 30%. Pundits continue to use the word “rally” in describing this recovery. This implies that the recovery may not be sustainable. However, moves of that magnitude have always been associated with new bull markets in the past. Let’s dig deeper into some of the dynamics of the current environment.
In fixed income, the rally in the highest quality assets seems to have stalled, with U.S. 10-year Treasury yields trading in a narrow range of 0.65% – 0.85%.
Meanwhile credit spreads, the premium one pays for taking corporate bond credit risk, have declined dramatically, particularly those in the high yield bond market, the riskiest segment of the market. Such low bond yields are a significant driver to higher stock prices. In short, the credit markets have responded to the therapy that the Federal Reserve (Fed) has injected with its massive dose of ‘liquidity’ medicine.
The Fed met last week and declared its continued therapeutic commitment to the market by keeping interest rates low for the foreseeable future and providing liquidity support through its asset purchase programs well into 2022 and a presumptive economy recovery. This news is music to a bull’s ears, reinforcing the more cynical interpretation by risk takers that “the Fed has your back”.
Last week the National Bureau of Economic Research (NBER) declared the U.S. officially in recession as of February 2020, which was a relatively quick pronouncement compared to prior recessions. The question we now face is when will it be over?
New bull markets begin well before the onset of economic recovery following a recession. However, an economic recovery and the associated improvement in revenues and earnings is required to validate the new bull market. At this point, there is a lot of uncertainty as to the shape and speed of the recovery.
The best outcome is for a “V” shaped recovery – one in which the economic activity (especially jobs) snaps back to previous levels. However, a “U” shaped recovery still seems more likely given the slow “normalization” process that both consumers and businesses face after the shock of the global economic shut-down.
To some extent, the comments from the Fed meeting last week are more consistent with the latter outlook – a U-shaped recovery. The Fed is forecasting sustained high unemployment well into 2022, with the rate of unemployment remaining above 5.5% until the end of that year. The Fed’s words and actions remain very cautious yet committed to providing every therapy measure possible to foster a sustained and durable recovery.
For the past few months, the financial markets have been acting in a manner consistent with the “V” theory – a snap-back in the economy leading to a quick recovery in revenues and profits. Some recent economic statistics have suggested the “V” recovery option may not be entirely implausible.
For example, the May employment report stunned the markets with expectations prior to the report of an additional 7 million job losses forecast. The actual reported number came in with 2.5 million jobs gained! It should be noted that there may be wide swings in employment statistics given the unprecedented nature of the government’s unemployment policies and the complexities that businesses are dealing with as they gauge how rapidly to ramp back up.
Another argument in support of the rapid recovery outlook has been the performance within certain sectors of the stock market. Recently the leadership in the equity market had rotated away from the more defensive and growth-oriented companies to those sectors that benefit from a reacceleration in economic activity like industrial companies and business sectors battered by the pandemic, like airlines, leisure and travel.
Small capitalization stocks, which are most sensitive to economic growth prospects, also rose sharply. The recovery in small cap stocks is indicative of investors’ perception that economic activity will pick up, credit will be plentiful, and profit growth will follow.
The counter argument to the recent short-term performance is that the previous relative performance differential between defensive/growth/large cap stocks and the more cyclically sensitive/small cap stocks had become too excessive and that the lagging sectors were due to “catch up.” After a meaningful narrowing of the valuation gap, defensive/growth/large cap stocks ended the previous week showing signs of once again reasserting their leadership.
Here’s what we know and don’t know (it’s the latter that always gets you).
It’s likely that the most significant wild card in the short term is the impact of reopening the economy. Should those actions result in an unacceptable reacceleration of infection, regardless of government policy, people will react and activity will slow. We don’t know enough about the virus yet to forecast this but, given the relatively short incubation times, the results should be clearly manifest.
Other risks will play out as time passes, but in the short-to-intermediate term, one should not underestimate the influence of central bank policies upon asset values. At the onset of the Global Financial Crises in 2008, a phrase often heard from policy makers was “we don’t have a playbook for this.” Now we do, and it appears the actions being taken this cycle recognize the potency of using multiple policy levers to support the markets and, in turn, the economy.
We remain cautiously optimistic that policy steps taken have been and will continue to strongly influence economic growth if there is not a resurgence in the pandemic.
Generally, asset valuations are quite full, particularly in the context of the uncertain impact on profitability engendered by the pandemic. The U.S. markets, particularly growth and defensive sectors, remain “rich” relative to the value, cyclical and small cap sectors.
However, relative valuation alone isn’t enough to downplay the group. They remain highly valued relative to other sectors given their superior operating performance and business characteristics that have proven to be quite durable and successful in an environment of economic uncertainty. Value, small cap, emerging markets, and developed international sectors are markets that are leveraged to a sustained acceleration in economic growth. Recent performance suggests that may be in the offing, but additional evidence is necessary to validate continued rotation into these economically sensitive businesses.
Media contact: Samantha Mehrotra, 612-844-4197; email@example.com
All information and representations herein are as of 06/15/2020, 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.
Thrivent Asset Management, LLC, a registered investment adviser and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans