Market Perspective for April 9th, 2016
A Correction?
The longer we remain below the January 26th high in the S&P 500, the more significant those highs become.[1] The term “correction” applies to a market decline that follows a market high. The implication is that the market’s longer term uptrend is intact, but it is just undergoing a period of consolidation. The longer the market goes without making a new high, the more that implication becomes questionable. If the “correction” has been fairly shallow and steady, so much the better in terms of the likelihood of breaking out to new highs. On the other hand, if the correction consists of a sharp fall, a rally that fails to reach the old highs, and another decline back to the lows of the initial decline, that is not as good. A correction that turns into a prolonged pattern of lower highs and lower lows is ominous. So far this correction has not seen lower lows, so the bulls still have the benefit of the doubt.
Continuing that thread further, growth stocks made new all-time highs on March 9th while value stocks continue to significantly underperform year to date.[2] See Chart 1 below. Furthermore, growth stocks did not have a closing low in late March or April that was below the February 8th closing low, whereas value stocks have had three. I must conclude that the much awaited (hoped for?) shift to value has not occurred. I have been tempted by the correction in “FAANG” stocks to change my models more toward value, but the supporting evidence is just not there. Dividend-oriented stocks tend to lose less on poor market days, but if a real shift had occurred, non-high yielding value stocks (financials, for example) would outperform on rally days.
Chart 1, Source: YCharts.com
Small Company Stocks
I do not think that small company stocks are particularly cheap, nor would I have interest in them from a cyclical standpoint (I believe we are late in the economic cycle and small caps do not typically perform well in recessions). That said, ever since the President brought trade sanctions to the top of his priority list, small caps have significantly out-performed large caps.[3] See Chart 2. The reason is simple – small caps are much less likely to earn a significant portion of their income from exporting, so they are less vulnerable to retaliatory measures. It is hard to foresee this issue going away anytime soon, so at this point I think it would be a real mistake to be underweight small company stocks.
Chart 2, Source: YCharts.com
If one is going to increase small company exposure, what would one sell and what would one buy, you might ask. I am no fan of increasing my overall stock weighting, so the proceeds have to come from stocks. I believe the argument can be made to reduce large cap US. stock exposure by 3% and reduce international stocks exposure by 2% (1% each developed and emerging; trade wars hurt everybody). I would increase U.S. small cap exposure by 2-3% and I would put the remainder in floating rate debt and/or cash. Floating rate gives me a better yield/return, but cash gives me optionality in the case of a sharp sell-off.
Short Term Debt
Short term debt instruments have seen a nice rise in yields lately. This is because the Federal Reserve has been raising interest rates and because LIBOR has been rising for a variety of non-alarming reasons. The two-year treasury note now yields more than the S&P 500. See Chart 3 below. Increasingly investors are asking themselves if the high volatility, modest return expectation they have for stocks is better than the safe yield they can get from government bonds or CDs. A high percentage of the gains U.S. stocks have experienced over the last several years has been from multiple expansion (as opposed to earnings growth), because investors felt there was no alternative. That attitude is fading.
Chart 3, Source: YCharts.com
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[1] S&P 500 per Stockcharts.com
[2] S&P 500 Pure Growth and S&P 500 Pure Value per YCharts.com
[3] S&P 500 versus S&P 600 per Ycharts.com