It’s been described as surreal. Despite the worst recession since the 1930s, an unemployment rate not seen since the same vintage, and a pandemic that’s killed over 925,000 globally, the S&P 500 hit its highest point ever at the start of September, recouping its Covid-19 triggered downturn and more.
Leading the charge has been the FAANGMs, namely Facebook, Amazon, Apple, Netflix, Google (Alphabet), and Microsoft. Because of their extended valuations and the market cap weighted construction of the S&P 500, they have caused many to regard the market as frothy. See the below chart from Yardeni Research.
September, however, has started out volatile. The litany of concerns includes the above average valuations, especially among those mega cap elite in the S&P 500. More important is the path of Covid 19, as investors weigh multiple hot spots around the world versus the prospects and timing of a safe vaccine and fast, accurate testing.
A much hoped for fifth relief bill has failed to date, causing many who received benefits earlier in the year to be left without additional Federal money.
As we move closer to the elections, worries mount over the outcome. Who will win, what will be his policies, and how should I protect my portfolio? What if we wake up the day after the election and there is no decision?
It is tempting to retreat from the market completely. However, we encourage longer term investors to consider adding to their portfolios from three asset classes that have been out of favor but may be poised to outperform.
In a Nutshell
Despite the recent correction in the mega cap tech favorites, valuations in these names are frothy at best and arguably downright absurd. Because of their hefty valuations, they assert an outsized influence in the major indices like the Russell 1000, the S&P 500, and the Nasdaq.
Other asset classes are cheaper and accordingly offer opportunity. While valuation is not a particularly useful timing tool, over the long haul it can be the ultimate arbiter of returns.
Attractive asset classes include international equities, small cap companies, and value stocks. Each of these classes has lagged for years and now could offer investors a path to better returns.
The Case for International Stocks
Over the last decade domestic stocks (S&P 500) have trounced international stocks (MSCI Intl ETF), outpacing them by nearly 11% annually. This has not always been the case; a Morningstar chart below shows the relative performance of domestic versus international, illustrating the cyclicality of the relationship.
Why have the last ten years been so decidedly in favor of domestic stocks? One reason is the US Dollar has appreciated significantly against other currencies. This reduces the value of non-Dollar denominated stocks and their earnings.
The US stock market has a different composition versus non-US stock markets. The US has a much greater weighting in techs and healthcare stocks. Conversely, non-US markets have more financial, energy, materials, and telecom names. We know that tech has had outsized returns in the last decade; based on its weak performance between 2000 to 2009 that’s not always the case. So, to the extent tech is overvalued and or is increasingly subject to heightened regulations or viewed as place to raise revenues (taxes), the US tech outperformance may not last.
Other analysts point to greater earnings per share growth in the US, partly fueled by an emphasis on share buybacks in the US. US financials have done a better job at recovering from the 2008-9 subprime downturn than their overseas counterparts.
Does this turn around? While the timing is uncertain, the superior valuations of overseas bourses suggest that they can provide future better returns. For example, the Vanguard Total Stock Market Index Fund (VTSMX) has a yield of just 1.54% and a price to earnings ratio of 24. Meanwhile, the Vanguard Total International Stock Index Fund (VGTSX) has a 2.3% dividend yield and a price to earnings ratio of 17.3. That suggests overseas stocks are 30% or more undervalued.
Small Caps Can Provide Non-Small Returns
Small cap stocks have trounced their larger brethren over the long haul, returning about 2% more per year since 1926. Indeed, even over the last 20 years, small stocks, as measured by the Russell 2000, have outperformed big stocks, as measured by the S&P 500.
What are small stocks? Small companies are distinguished from larger ones by their much smaller market capitalizations, or value in the marketplace calculated by multiplying their share price by the number of shares outstanding. Small caps have market caps of between $300 million to $2 billion to $5 billion, while large caps start at $10 billion and go on up to $2 trillion (Apple).
Why would smaller caps outperform over the long haul? First, they are far more volatile; economic theory suggests that more risk can produce more reward. Second, as smaller fish, they are far more likely to be bought out, typically at a fat premium. Third, there is less liquidity, making them harder to trade, a problem for big institutions. A higher potential return is accordingly demanded. Finally, there is less analyst coverage, less information available. That can cause investors to demand higher expected returns.
Despite the long-term superior performance, in recent years small caps have lagged, returning nearly 7% less annually than the S&P 500 over the last five years. Year to date through the end of August the Russell 2000 has returned nearly 14% less than the S&P 500.
The risk factor loomed large this year. In just one month’s time, February 20, 2020, to March 18, 2020, the Russell 2000 fell just over 41%. That drawdown rivaled the 44% drawdown in the Dot Com collapse and the 59% sell off amid the subprime crisis. Interestingly, those slightly bigger drawdowns were multi-year affairs, versus the over 41% selloff this year in about 30 days.
So, why small caps now? One reason is their cheaper valuation, about 10-20% less than large caps, even though small caps are often more expensive. Second, reversion to the mean is quite possible. Smaller companies can outperform in order to equal or exceed the performance of larger companies over the last few years.
Some theorize that smaller companies have less exposure to overseas economies, a plus amid the trade wars. Small company indices do have more exposure to financials than do large company indices. If interest rates rise and the economy improves financials may thrive.
Value Stocks May Yet Have Their Day in the Sun
For nearly 100 years value stocks trounced growth stocks, up 1,344,600% versus just 626,600% for growth stocks, according to a Bank of America study. Yet, since 2007, that approach has fallen short, to the tune of 8% annually. See the chart below:
Definitions of value stocks relative to growth ones are not uniform. Most analysts consider low valuations, meaning a low stock price relative to book value, earnings, sales, and or cash flow as value indicators. Who wouldn’t want to pay less for those attributes? However, growth stock investors will pay more if their crystal balls indicate the future growth in those metrics is faster than the average company.
There are several great reasons why value stocks may start to outperform their brethren.
First, the value discrepancy has gotten too large. Even if value will always be cheaper, it’s just too cheap now. After similar periods when such a disparity opened, in 2003 and 2008, value outperformed.
Much of growth’s ascendancy may be due to the record low interest rate environment. With rates low, the discounting the market attributes to distant cash flows lessens. A dollar to be received in a decade isn’t worth much less than a dollar in hand today. However, if, as many predict, interest rates rise as the current uncertainty ends and or the recent money creation and deficit spending trigger inflation, that may prove a headwind to growth stocks.
Others simply point to the mean reversion history of the markets. When one sector dramatically outperforms another, the stretched rubber band eventually snaps back. Indeed, analysts note that in the past when the value dispersion has been this great, value has outperformed growth 95% of the time.
Finally, the recent winners may risk government regulation. Washington and other world capitals are scrutinizing the mega cap growth names for monopolistic practices, possible breakups and tighter regulations, and or as a source of more tax dollars. This may trigger a rebalancing from growth to value.
Nothing guarantees that international, small companies, or value stocks will start to outperform, despite favorable factors. Historically, these asset classes have been more volatile than large cap domestic blue chips. Investors may wish to tread carefully in these areas, but they do appear to offer a way to diversify away from many of the frothy domestic large cap growth names.
Note: David Dietze is President and Chief Investment Strategist at Point View Wealth Management.
Point View Wealth Management is an SEC-registered investment adviser and part of Peapack Private Wealth Management. For over 25 years, Point View Wealth Management has been providing customized portfolio management services and comprehensive financial planning solutions for individuals and their families to develop and achieve their financial goals.
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