Last week brought good news to Wall Street. Greece’s bailout terms were approved, China’s government measures stopped their market slide (for now), and US earnings kicked off with a medium-volume bang. Meanwhile, Barron’s cover on Saturday highlighted significant upside for Japanese blue chips, Angela Merkel hinted at much-needed debt relief for Greece, and oil pricing became slightly easier with the completion of Iran’s negotiations.
Stock markets don’t necessarily need good news – it’s certainty that matters more, in our opinion – so investors can price assets appropriately. When both get combined, we get rallies – and that’s what drove markets worldwide, including Europe, Japan, South Korea, India, and the US last week with the factors above. Countries dependent on commodities including precious metals, of course, are sitting out at the moment, but that’s a story we’ll be covering next weekend. The focus right now turns to fundamentals; we’re talking about quarterly earnings from the S&P 500. Last week, the titans of the world – Facebook, Google, and Netflix, blew through the roof on the backs of news and results far beyond investors’ expectations. Apple, Coke, IBM, and several dozens of firms are on tap this week to announce earnings. The S&P 500 finds itself up 4.4% YTD, while the Nasdaq is up over a massive 10%. We’re noticing a new-found laggard, though – a sector which needs some support considering the role it plays in the US economy: the small caps, up only 4.1%. Here’s why we think it’s a good time to invest in this sector if you haven’t already:
– Small caps are significantly sheltered from currency headwinds, considering they derive over 80% of their revenues domestically, compared to less than 60% for large caps, according to the Bank of America last year. With the Euro reaching YTD lows last week, the Yen also continuing downwards, a rising rate environment in the US and quantitative easing abroad not going anywhere, there’s really little reason why the dollar should reduce in strength, if not go higher. Small caps won’t be as affected, and a reallocation from the large caps to this sector may occur soon by the market. We think it’s wise to be ahead of it.
– Small businesses employ over 90% of the US population. Consumption’s the bread and butter of the US economy (at 68.5%, above recent historical levels, according to JP Morgan), and we’re fine with utilizing small caps as a proxy for this. Factor in that unemployment per the basic U3 definition should be reaching near-full levels around 5% if the hiring trend continues, inflation is slowly trending upwards, and wage growth should occur in the coming months as the real GDP and potential GDP gap narrows. All in all, if the domestic consumer benefits, we think small businesses and small caps will benefit – and vice versa. A strengthening economy helps everyone – including stocks.
– US small caps are incredibly diversified, with the largest sector consisting of financials – at over 20% of its total market cap, compared to the S&P 500’s technology sector, which derives much of its revenue overseas, and is a bit expensive in the short term given recent run ups in the mega caps. Financials, meanwhile, are expected to be the largest beneficiaries of interest rate hikes. As a result, the small caps’ index composition – say, the S&P 600 – is in favor of the rising rate environment in the US.
– Small caps may seem a bit bit expensive, at nearly 110% of their 20 year P/E average of 17.4, per JP Morgan data. However, the premium that small caps have had over the large caps in terms of P/E has decreased significantly, at only about 20%, compared to the historical average of 45%. The S&P 500 is above average as is, at nearly 17x forward P/E compared to the mid-15 historical average. However, as we’ve mentioned before, we need to factor in the fact that 10-year Treasury yields today are around 2.3% compared to the past’s 4%+ average, and as a result, what was ‘expensive’ in the past may not be applicable today.
– At the same time, leverage matters – especially in a rising rate environment. High quality firms are often chosen based on their return on equity. However, this metric can be manipulated by loading up on debt; if you combine the two, it’s a better approach. The MSCI Quality Index, for example, consists of three fundamental factors in choosing stocks – high return on equity (ROE), stable year-over-year earnings growth and low financial leverage. It outperformed the S&P 500 over the past 15 years, and while the index itself focuses on large and mid cap stocks, there’s no reason for the same philosophy to not be applied to small caps too, if you’re more into stock picking.
What it means for you: Since the lows of March 2009, small caps have outperformed the large caps, up approximately 300% compared to the S&P 500’s 248%, as of June 30th (JP Morgan data). Media coverage today, due to macro events, continues to revolve around large caps, and investors are racing to the winners – seen by last week’s quarterly results. Barron’s Randall Forsyth called it interestingly this weekend by highlighting an expert quote stating that ‘narrowing leadership is typical of the late stages of a lengthy bull market’. The debate continues on what stage today’s market is at among analysts and experts, but we’re pretty optimistic on the state of small caps. Unlike other economic recoveries, the US consumer has significantly lagged in realizing the benefits of this expansion post-2009. We think the conditions are in their favor today, and it makes sense to stay aligned with them by keeping some exposure to small caps as Wall Street and Main Street merge together in the coming months.
