The big-time potential of small cap stocks [PODCAST]
Pinpointing winners requires a sound investment process.
Pinpointing winners requires a sound investment process.
The stock market surge from its March 23rd low is arguably more stunning than its collapse from the February market peak. It has been the largest market rally in such a short period of time on record.
The S&P 500® index is up approximately 56% since March 23 while the mega-tech heavy index, NASDAQ 100, is up approximately 70%. Apple, the largest company in the world by market value, is up an astounding 125% over that same time frame!
This has happened during a period when economic statistics, such as employment, gross domestic product (GDP), and industrial production swiftly fell to levels that have historically been concomitant with severe recessions.
In addition, the significant uncertainty of the coronavirus persists along with the greatest social unrest since possibly the 1960’s and an imminent U.S. presidential election. However, unlike the March collapse, this market recovery has not been accompanied by banner newspaper headlines or surging inquiry from anxious investors asking what is going on?
The simple answer is massive injections of support globally from central bankers, who flooded the financial system with money, and from federal and state government policy makers who implemented vast transfer payments and other support mechanisms to maintain “paychecks” for consumers and cheap loans and grants for businesses.
These moves in total dwarf the level of support that government entities provided during the great financial crisis of 2008. This tsunami of a liquidity wave drove interest rates down to record levels, which in turn made equities look compelling as an investment alternative.
The global coronavirus lockdown also magnified and accelerated business trends that have been ascendant for years, such as technology companies remaking the economic landscape. These mega-tech behemoths posted stunning profits and cash flow during the economic collapse of the 2nd quarter. This narrow group of industries and companies became the driving force behind the surge in the overall market indices.
From an economic perspective, the Federal Reserve (Fed) remains a critical element going forward. The Fed today announced the results of a recent review of its goals, policies and tools. The conclusions are effectively “more of the same,” however with some updating of their goals and policies.
The Fed has had a long-held goal of targeting 2% inflation while maintaining “full employment” for the economy. In a nuanced but important shift, the Fed will now be more flexible in maintaining its easy monetary policy (effectively 0% for short term funding while continuing its asset purchase program), even if inflation moves above 2%.
The rationale is that policy will look at average inflation over an extended time period before responding with any policy change.
The Fed is also modifying its policy regarding employment. Its “full employment” mandate seems to now be at a modestly higher priority level than its inflation mandate. And like the inflation mandate, the Fed will be more flexible in how it perceives the achievement of “full employment.” Obviously with unemployment levels at excessively high levels currently due to the pandemic, the economy is a long way from hitting employment levels that would be of concern.
The bottom line is that this Fed policy review supports the market’s perception that short term interest rates will remain exceptionally low for a long time, and the Fed will remain vigilant to support markets when needed.
Unlike the clarity the Fed is providing on monetary policy, government fiscal policy is very uncertain due to the usual politics, but now is complicated by a presidential election. Currently the only thing that Democrats and Republicans seem to agree on is that additional fiscal support for consumers and for business is needed as the pandemic maintains a heavy weight on the economy.
However, both sides remain far apart on total dollars and specific details. It is expected that doing nothing is fraught with too much political risk for both sides, so expect a total package of $1-2 trillion as a fourth phase of stimulus. In any other environment this amount of fiscal support would be viewed as unprecedented. Now it just seems a necessary element to provide a “financial bridge” to a post COVID economy.
A bigger question that investors are beginning to scrutinize will be policy changes, and especially tax policy changes, after the November election.
Recall the extremely significant impact that the 2017 tax law changes had on pushing stock prices higher. Currently it is too speculative to have any clear outlook on this, since it is contingent not just on who wins the presidential election, but also on what happens in the U.S. Senate and the House of Representatives. It does seem highly probable that if tax rates on individuals, corporations or capital gains are increased, the markets would give back some of the strong gains that have been posted this year.
For an investor who either felt great stress during the last market collapse, or for those whose financial or life circumstances have changed, such that a lower risk exposure to the market is warranted, now is a good time to go through some “de-risking” by reducing equity exposure.
However, investors should always keep in mind the long-term implications of such a move, given that over long periods of time, equity markets have provided returns that are substantially better than cash or high-quality bonds.
In assessing an investment portfolio after such a strong move, portfolio management 101 prescribes looking at where a portfolio is relative to its long-term allocation strategy and making rebalancing moves.
Typical “big picture” rebalancing efforts historically would result in reducing equity allocations back to strategy while increasing fixed income allocations. However, in this environment, where long term interest rates are at extraordinarily low levels, it may be prudent to rebalance to a much shorter-term fixed income alternative rather than to longer-term fixed income instruments. (See Helping Your Clients with This Alternative to Money Market Funds)
Cash may be an alternative, as well, but with money market funds currently providing 0%, they are not an optimal option. As an aside, there will be an enormous amount of global bond supply coming to fund massive support programs. The markets have thus far been able to absorb such supply. However, the magnitude of future bond issuance and the potential inflationary impulse that it may create could cause long term bond yields to rise. However, that is a potential problem further out in the future.
Although long-term, high-quality bonds such as U.S. Treasuries have little appeal, certain segments of the fixed income market offer better relative values.
These include short to intermediate maturity corporate bonds, mortgage-backed securities and select higher risk markets such as preferred stocks. Finally, although municipals have performed very well since March, they remain relatively attractive for high marginal tax bracket investors. Municipals could get a further relative performance boost if tax rates move higher. Still, with rates so low, investors should not expect much in terms of excess return from their fixed income holdings. They still provide an important diversification element to a portfolio, however.
The stunning equity rally we have seen has been extremely focused on domestic large cap growth stocks, while international markets have lagged. Now may be a good time to increase allocation to international assets with a modest overweight to emerging market equities. Foreign economies, and especially Asian economies, are currently less impacted by the pandemic since they went through it much earlier. Also, the dollar has finally begun to trade weaker in the foreign currency markets. This trend, if it persists, will be a strong support for international markets denominated in local currencies.
In the U.S. market, the fundamentals continue to support growth businesses and especially large cap growth. Value market sectors such as Financials and Energy remain challenged by not only the pandemic environment, but by big secular shifts affecting these industries as well. Although valuations look quite cheap by historical standards, these low valuations seem warranted given long-term headwinds. Value sectors may get a “trading pop”, but until there is a solid cyclical economic recovery, value sectors will remain challenged.
Small cap stocks are starting to show some “green shoots” of encouraging performance relative to large cap. Valuation of small cap stocks relative to large cap seems compelling, but it will take more evidence from earnings to validate a more significant move into small cap stocks. Thus, it may be appropriate to add some small cap exposure currently as part of a re-balancing, with an eye to more materially increasing an allocation to this sector as confidence in the economy and in small cap earnings improves.
Stay safe and stay engaged and committed to a well-thought-out long-term approach to your portfolio.
All information and representations herein are as of 08/27/2020, 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.
This article refers to specific securities which Thrivent Mutual Funds may own. A complete listing of the holdings for each of the Thrivent Mutual Funds is available on thriventfunds.com.
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.