The big-time potential of small cap stocks [PODCAST]
Pinpointing winners requires a sound investment process.
Pinpointing winners requires a sound investment process.
POST ELECTION UPDATE
As the year winds down, it goes without saying that 2020 has been a year like no other. A microscopic virus triggered a global pandemic, which led to both a severe recession – followed by a recovery – and a stock market collapse – followed by a stunning recovery.
It also contributed to the environment that led to social unrest with no apparent recovery. All this fed into a bitter presidential election, leading to a new President-Elect, but with little evidence of recovery in relations between the two dominant political parties in the country.
All of this historic turmoil created tremendous anxiety and volatility in the financial markets. But in looking at overall investment returns from the beginning of the year until now, it is surprising that 2020 is a year very much like many others, albeit with a vastly wider dispersion of returns across various market sectors.
Although the S&P 500® Index is up approximately 10% year to date, only five mega cap technology stocks, which collectively are up nearly 50%, have been the fuel behind the broader market’s advance. Stripping out these five stocks, the other 495 stocks in the S&P 500 Index are up collectively a modest 4%. Many economically sensitive stocks, especially in Energy and Finance, have suffered significant declines. International markets have badly trailed the U.S. market, with basically flat returns. Meanwhile the bond market has generated solid returns of 5-7% year to date, but has been driven predominantly by price gains, not coupon income.
Most investors have, or should have, well diversified portfolios. Such portfolios include domestic and international stocks, including growth, value, large-cap, and small-cap allocations. They also have some cash, high quality bonds and lower quality bonds to generate income and provide “ballast” to a portfolio.
Returns of broadly diversified portfolios, but with differing levels of risk, are remarkably similar this year. Using median return data from Lipper Analytical Services, a moderately conservative multi-asset portfolio (featuring a high bond allocation) is up approximately 5% year to date, while an aggressive multi-asset portfolio (featuring a high stock allocation) is up approximately 6%. This is quite a narrow performance differential given the very different levels of risk. Still, these overall portfolio returns are well ahead of inflation and are also in line with long term expected returns.
Going forward, it is quite unlikely that there will be such homogenous overall returns for portfolios with very different asset allocations and risk profiles.
The winds of change are beginning to blow in the political, economic and medical research landscapes. These changing winds are also affecting the financial markets and prospective relative returns across asset classes going forward.
Politically the changing winds have led to a new President-Elect. Although Joe Biden won a somewhat narrow victory in the electoral college, the widely expected “blue wave” that would have captured control of the U.S. Senate has not yet materialized.
The equity market has reacted favorably to a presumed split in political power, given that such a split would reduce the chances of a dramatic shift in tax policy, while increasing the chances of near-term fiscal stimulus. These political winds will remain unpredictable in the few months ahead, given legal challenges to the election results, potential actions that a lame duck president pursues, and reaction to new cabinet candidates and policy ideas that President-Elect Joe Biden will initiate.
The biggest, and most soothing, changing wind “gust” is coming from the extremely positive news regarding the development of vaccines to combat COVID-19.
Success on the vaccine front has always been the key to stabilizing and buttressing the durability of the economy and markets. If successfully developed, rapidly produced in scale, efficiently distributed, and widely embraced by the public, a COVID-19 vaccine is a game changer for the country and for the economy.
Recent news on this front is very encouraging, but it comes at a time when COVID-19 infection rates are stressing the healthcare system and leading to rapidly rising death rates. This changing wind will ultimately be the catalyst to lifting the cyclical sectors of the economy and markets that have so significantly lagged those sectors that have sailed through, if not prospered, during the pandemic.
In addition to these changing gusts, the prevailing wind from the Federal Reserve (Fed), and from other global central banks, continues to provide the lift that is supporting global economies and markets. This “jet stream” of monetary support and liquidity will persist. However, although the Fed exclusively establishes monetary policy, it works closely with the U.S. Treasury on economic policy and financial regulation.
With a new president, there will be a new U.S. Treasury Secretary. Also, there remains two open seats on the Federal Reserve Board of Governors that the current administration could fill before inauguration day. Consequently, expect some modest disturbances. However, the prevailing wind of accommodative policy and the stable leadership of Fed Chairman Jay Powell will continue to lend strong support to the financial markets.
The changing winds on the political and vaccine research fronts, combined with the ongoing “jet stream” of liquidity provided by central banks, is beginning to change the direction of various sectors of the capital markets.
In the bond market, interest rates have begun to rise, the yield curve has become steeper, and credit spreads have improved. In short, the rally in the high-quality bond market seems to be over. This is happening even as large inflows into bond funds continues. With the Fed pinning short term rates at 0% through 2023, and no clear evidence yet of inflationary pressures, it is hard to see a major decline in bond prices (higher yields) in the near term. However, with bond yields so low, high quality fixed income investments – especially treasury bonds – will not provide the income and diversification benefits to a portfolio as they have previously.
In the stock market, there are preliminary signs of investors rotating from the long-time winners of large-cap growth stocks, especially technology, and into more cyclically sensitive areas such as value and small-cap stocks. There have been some false starts on this rotation trade over the past few years as the incredibly strong earnings delivered by large-cap technology companies has dominated the more anemic earnings results of other sectors.
However, this sector is now very highly valued in the market. In addition, there are now some cold “breezes” of more regulatory challenges for the mega cap Technology sector. It will take decisive news on the efficacy of the vaccine effort, along with clear signs that the cyclical sectors of the economy are improving for the large-cap growth sector to give up its leadership role in the markets.
But the relative performance and valuation gaps are now so wide that beginning a move to the small-cap, mid-cap and value sectors of the market seems warranted. If nothing else, disciplined investors may want to consider rebalancing their portfolios to their long-term strategic allocations to the value, small and mid-cap sectors of the market as the U.S. prepares to inaugurate a new administration.
All information and representations herein are as of 11/13/2020, 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.
Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
Past performance is not necessarily indicative of future results.