One asset class has rebounded to new all-time highs — U.S. small cap stocks.
After a bullish 2017 and hopes of a continued global equity melt up, 2018 has instead reintroduced market volatility. Despite global market volatility, U.S. small cap stocks have rebounded to new all-time highs.
Factors influencing the success of U.S. small cap stocks
So what factors has caused this success versus larger capitalization stocks?
Compared to large cap stocks, small cap stocks tend to do better in strong economic cycles. The first half of 2018 has been just that, and we expect more of the same in Q3 and Q4.
Small cap companies benefited most from the deep corporate tax cuts as most of their sales take place domestically resulting in higher tax rates when compared to their larger multinational peers.
The domestic focus of most of these smaller companies makes them less vulnerable to the ever-changing trade talks and tariffs between nations. Domestic sales generate all of their revenue and they export minimal goods. If anything, retaliatory tariffs could boost earnings of smaller companies with a domestic focus for the remainder of the year.
Targeting small cap stocks
The small cap premium is one we explicitly target in our portfolios. Given current market conditions, we see great opportunities for this asset class. Please refer to Evidence Based Investing for a more detailed look at our investment process.
While the S&P 500 remained near its all-time high, the recent massive selloff in the technology sector went mostly unnoticed. But for investors who follow the so-called “FANG” stocks (Facebook, Amazon, Netflix, Google) the hit was painful: About $60 billion in value was wiped out in just one afternoon, representing the largest selloff in nearly 2 years.
The wipeout was a function of just how big these companies have become and the position they are in with new tax reform looming. Tech companies are expected to receive little benefit given its already-low average tax rate of 18.5% (below the 20% proposed rate).
This has caused investors to rotate out of the tech stocks and into the financial services sector, which stands to benefit more from a corporate tax rate that would drop from the current 35% to 20%.
Interestingly, the S&P 500 was relatively unaffected while this rotation into financials and out of tech ensued. The index’s volatility actually remained low, as did correlations among the S&P 500’s member stocks.
In other words, the diversity offered by the S&P 500 Index allowed for the index too remain relatively unscathed by the trading within the tech and financial sectors, a key reminder to investors that having proper exposure across the markets continues to be important with the S&P 500 near its all-time high.
Being a resident, I have experienced Denver’s hot housing market first hand. All residents can attest to the fact real estate has a short shelf life in this town. An influx of out of state buyers who regularly comes in with cash to quickly buy up our already low housing inventory. I have always wondered where this cash is coming from. Are buyers liquidating investment assets to purchase a home in Denver under assumptions of continued year over year real estate appreciation?
As I discussed in my last blog, investor participation in the stock market is at an all-time low. Does this mean investors are stock piling hordes of cash for future use? No. We know people are still investing with hopes of better returns than what is earned in their savings accounts. So, who are the recipients of these funds? According to Gallup, real estate is the current preferred driver of net worth. When looking at the chart below, I would have to say that Americans’ view of the stock market as the best long-term investment option is changing.
Over the past few years there has been a steady increase in real estate investing. Thirty-five percent of Americans now choose real estate over stock and mutual funds. Both asset classes suffered catastrophic losses during the great recession and both have now recovered to well above their pre-crash highs. But Americans now seem to have more confidence in real estate than the stock market. I hope they understand the risks associated with direct real estate investing; illiquidity, expensive to exit, high entry price… but that’s for a later discussion.
With the U.S. markets hitting record highs, one would assume more adults would be participating in the stock market when compared to previous years. Since the last financial crisis, we have not experienced an increase of stock market participation. The equity markets continue to march forward and the participation in these gains has not. Per research published by Gallup, a little more than 52% of Americans’ currently have money invested in the stock market. As you can see in the below graph, this matches the lowest ownership rate since 1999. During the high in 2007, nearly 2 out of 3 adults had money invested in the stock market. Did big losses experienced in 2008-09 change Americans’ sense of confidence in the stock market?
You may have have heard, or likely will soon hear about, a relatively newer investment approach that has gained popularity over the past 10 years called fundamental indexing. Fundamental index vehicles have plenty of aliases such as: strategic beta, smart beta or factor investing. At the core, fundamental indexing is about creating a better index (pool of securities) by excluding certain companies and including others based upon a defined financial filter. It is less about picking the best company and more about picking a pool of securities that has what is believed to be more desirable long-term financial characteristics. The growth of this segment has been impressive to say the least. Morningstar reported growth of the “Strategic Beta” category to $745 billion as of February 2017.
“What goes best with a cup of coffee? Another cup.”
Thus far, 2016 has been an interesting year for money managers. We have seen the recent market rally mask some of the greatest market volatility experienced in five years. If you think back to the beginning of the year, you’ll remember the worst start to the calendar year ever for the S&P 500. As recession fears subsided, stocks rebounded and we closed at a new record high on the S&P 500 yesterday. We have also seen a reversal in commodity prices.
From a total return standpoint, the S&P GSCI, the commodity index, sits atop of its equity counterparts. The increase in commodity prices have helped subdue the concerns of a global recession, but also comes with drawbacks. The clear drawback is the price to fill your car. We have seen prices at the pump increase over the year as oil prices have risen and now hover around $50 per barrel. Another downside, one not as publicized as other commodity prices, is the price of coffee.
Thus far, the 2016 presidential race has been nothing short of surprising. It has been laden with controversy and criticism. With a victory in California, Hillary Clinton is the clear democratic nomination frontrunner. Donald Trump, the only Republican candidate left in the race, has won enough delegates to clinch the GOP party nomination.
While the outcome of the election is still months away, history suggests the markets respond far better to a predictable outcome. Markets hate uncertainty. Investment managers will seek clarity over the coming months by looking carefully at the economic proposals of each candidate. For example, markets might respond well to a reduction in the corporate tax rate, a bullish economic indicator. Party affiliation does not offer much insight into strong or weak performance of capital markets. We can look back to times when markets have performed well under both parties.
The turmoil in the energy sector was widely publicized since the historic decline of prices starting mid-2014. This has largely been due to a glut of oil in the market with relatively flat demand.
As a result, the energy sector was plagued with volatility and decreasing prices as investors fled for safety.
This negative sentiment has spilled over into what should be an uncorrelated segment of the energy industry: mid-stream providers. Think of mid-stream as an infrastructure of toll roads that transport and store units of energy, not just oil. As Jim Callahan discussed in his latest edition of Portfolio Matters, the U.S. pipelines currently transport 70% natural gas and 30% oil. The demand globally for oil has decreased the volume of oil flowing through pipelines, but natural gas production is growing. The Energy Information Administration, estimates that natural gas consumption will increase by 60% on a global basis by 2040. The U.S. is the largest producer and exporter of natural gas and estimates point towards an increase in volume of 9% in 2016. While oil gets all the press, we remind our clients that its natural gas that is more important to the U.S. mid-stream MLPs, and because of this, we are very comfortable with our mid-stream focused investment thesis.
On Wednesday, the Fed decided to put an anticipated rate hike on hold for at least another month. The planned hike was curbed due to the recent volatility experienced in the market. Although the job market has been resilient during this weakened economic period, broader economic factors have caused a period of increased market volatility, measured by the VIX index. U.S stocks have rebounded in the past month, mainly due to improving data, rising oil prices and an accommodative stance by central banks around the world.
When building an efficient portfolio, most market practitioners would agree to an allocation to bonds. This allocation reduces the overall volatility of the portfolio and adds a layer of safety. The two main components affecting fixed income returns are: 1). interest rates and 2). the credit quality of issuers. With the recent increase of interest rates and the Fed’s plan to incrementally increase rates over the next few years, we feel investments in credit, especially high yield, offers better return potential to investors.
High yield bonds tend to deliver the potential to improve a portfolio’s overall risk/return given the historically low correlation with other core asset classes. Due to their location on the credit spectrum, high yield bonds offer enhanced yields compared to high quality bonds and can potentially increase the overall yield of a portfolio significantly. Although this has not been the case as of late, historically speaking, high yield bonds have provided better downside protection than equities while delivering equity like returns with significantly less volatility and drawdowns.