One of our favorite websites for years has been Sentimentrader.com and this morning they posted a brief review of what to expect when Small Caps start to lag Large Caps while the SP500 is hitting new highs as it is today.
To sum it up, the lag usually continues. Since 1978 there have been 18 similar circumstances but going forward the SP500 returned on average of +14% while the Russell 2000 returned +9.5%. Either way, its still pretty good but no sense in leaving money on the table.
In recent history, 1991 was the one year when Small Caps continued to excel, but in 1997 and 1998 the divergence between the SP500 and Russell 2000 was very pronounced with returns of +20.7% vs -8.4% and +16.1% vs. -1.8% respectively.
*Data from Sentimentrader.com
We’ve finally exited the last of our China Automotive holdings at $14.80 yesterday, no doubt it will now run to $30. The stock is so extended with the 60 day moving average at $10 that the risk of holding on to it during this parabolic move seems to great to me. It had become such a large holding after tripling in value in many accounts, that it felt like a suckers bet to hang on for more.
Meanwhile the Russell 2000 index which is a proxy for Small Cap stocks continues to labor and appears to be rolling over, not a good sign. While I don’t think the market as a whole is ready for a collapse, strength is narrowing which is a likely sign of a maturing market rally.
Of the top performing groups of 2009 only Information Technology remains a group with leadership strength. Right now I’m compiling a list of stocks that rank high in our proprietary model and show positive chart patterns. But its too early to name names just yet.
In addition to equities, I’d love to get an entry point to add Gold to portfolios. Recent action in long term bonds implies that inflation may be around the corner which will put the Fed in the impossible position of trying to create jobs and fight inflation ie Stagflation could rear its head. But Gold’s climb is unrelenting. Ideally I’d love to see the UGL come back to around $43 a share as that could be a good entry point in what could likely be a bull market in Gold.
Long UGL
As a follow up to last weeks letter, we’re pressing our transition to high quality large caps after the tremendous run in the Small Cap market. The Price / Earnings ratio of Small to Large shows that PE’s are 60% higher for Small Caps versus Large. The risk reward of Small Caps isn’t that attractive at present. Adding to this is the fact that while the Dow and S&P 500 are hit a new high yesterday, the Russell 2000 hasn’t even made it back above its 60-day moving average, in other words Small Caps are beginning to lag.
The Russell 2000 peaked on 9/19 and since that time Small Cap stocks which comprised the bulk of portfolios have lagged or at least not been on the rampage they once were.
In addition the valuation gap between Small Caps and High Quality Large Caps is significant to the point to make me go “hmmmm”.
In addition, during the last recession in 2003, small caps lept ahead during the first leg of the rally into December. However, by 2004 Large Caps took the lead for the year and in back testing our model did extremely well. I’m following what I think could be similar pattern in 2010 as Large Cap / High Quality starts to assert itself, especially with a declining dollar. We’re not abandoning Small Caps, just adding more Large Caps in lieu of Small for balance.
Damn Yankees. You just had to know if they lost the World Series they’d spend even more money this off season.
Summary: The epic rally of the past 7 months has appears to have hit a wall at 1100 on the S&P 500. This does not mean we cannot rally beyond 1100 or that the market must now decline, trending sideways for a period of months may be the likeliest scenario. The time period of November to April is historically the strongest six months of the year, particularly November and December, so strength into the year- end is a possibility. Lowry’s Research has stated they expect the current pullback to be short term. Our strategy of Small Caps over Large Caps is still in force although I’m reviewing future holdings as the weaker Dollar tilts the odds to favor Large Caps. My thought is that going forward the disparity between Small and Large Cap stocks will narrow. The US stock market is no longer “Undervalued” but merely “Fairly Valued” in my estimation we are reducing exposure to stocks periodically on strength which I expect by December.
Back in the Spring I proposed that the stock market would initiate a rally of historic proportions with a target of 1100-1150 sometime in 2009. This prediction was based on past precedents the belief that no one at the time was discounting the end of the recession by Summer. This target was breached on October 21st. While I consider the stock market now fairly valued, the signs of a classic major top in the stock market are simply not present at this time. The current pullback has the ingredients of a short-term correction rather than the start of a new leg down. Major tops take time to develop and our timing service Lowry’s points out that “Every major market top in Lowry’s 76 year history has been preceded by a sustained rise in Selling Pressure.” There is no evidence of a sustained rise in Selling Pressure at this time.
Adding to the lack of incentive for a new down-leg in stock prices is the fact that interest rates are at minimal levels and while market valuations are fairly valued at 14.5 normalized earnings, which is about 2 multiple points less than historical averages. Since 1932, the six months after the end of the recession has seen gains on average of 9%. Curiously, the two market years most resembling the past year: 1938 and 1975 saw gains of only 3% for the next six months after the end of the recession. In addition, small cap outperformance is maintained by an average return of 7% in the six months following the end of a recession. The issue of Small Cap outperformance is subject for review due to the effects of the declining dollar. A declining dollar assists the performance of Large Cap stocks. Small Caps peaked on September 19 and if the trend of Small Cap’s lagging performance persists for another month, future additions will be Large Caps.
Believe it or not we’re going to get an economic recovery, it may be anemic by historical standards but it will be a recovery. Due to the stimulus package there will be a significant infrastructure build out in the US starting in 2010. Warren Buffet’s purchase of Burlington Northern is a classic smart move to get in front of the infrastructure build.
The 3rd Quarter of 2009 turned into quite a prosperous quarter for RMHI clients as our exposure to small cap equities with international diversification has been a winner since the market bottom in March. While the past few months have been quite good, I believe that going forward gains will moderate especially if we stay in a trading range with 1100 on the S&P 500 being the top end of the range.
Historically speaking, the period post-recession has produced gains but to a lesser degree than the period preceding the end of the recession. In other words, its likely that the “easy money” has been made (as if its ever “easy”!) but there still are gains to be made although our exposure to equities will be reduced as the risk reward is not quite what it was in March. There is always the chance that unknown world events could throw a Molotov cocktail into the markets, so having cash off the table could prove to be prudent.
Until there is solid revenue growth in the US, my view is that we could be entering a period of market digestion, not unlike what we experienced in 2004 (the SP 500 did return +8% in ’04). Gains were still made just not nearly at the rate in 2003. Small cap GARP (Growth at a Reasonable Price) should still outperform, just at a lesser pace.
It seems to me that in the past 10 years we’ve bounced from Bubble to Bubble which eventually pop sooner or later. The current interest rate environment is unsustainable in my view, but the hazards of reaching for yield by going out farther and farther on maturities could be the next major bubble to pop. Timing is next to impossible to predict but it could be within the next two years.
The current 0% interest rate environment induced by the Federal Reserve has created a curse on holding cash. The 0% return is forcing investor’s including retirees to invest in increasingly longer term maturities to gain incremental increases in yield. Desperate to increase their yield they’ll be very vulnerable to a pullback in bond prices. While the Federal Reserve controls the yield and price of short term Treasures, market forces have a much greater influence on longer term maturities and the Fed’s support of Treasury prices will eventually end. Fear continues to guide their decision making as equities were almost completely avoided this Spring which means they missed the 20% + returns in favor of bonds yielding 2%-4%. The lure for this move is the perception of “safety” but in the longer term this perception could be a very elusive mirage.
The catch is that our deficits and issuance of debt is having a declining effect on the dollar and at some point investors, especially foreign investors will demand higher rates for the risk of owning Treasuries. While the debate over future inflation is mute at this point, my view is that eventually interest rates must go higher eventually, especially if we experience declines in unemployment in 2010. What would happen to the prices of long term debt should rates rise to 7% or even 9%, the collapse in bond prices for those investors would be devastating. This is the basis for my belief that should employment rebound in 2010 or 2011, it could be accompanied by a significant pullback in stock prices, which would take their cue from falling bond prices and higher yields.
I realize the returns on short-term debt are almost next to nothing, but the risk inherent in owning short-term debt during an interest rate spike is not nearly as significant as longer-term maturities. I’d rather be safe with our ownership of short-term bonds rather than the higher yielding long-term maturities. Short term interest rates are set primarily by the Federal Reserve and its my view that those rates will not rise until a meaningful increase in employment is underway, this could remain elusive for most if not all of 2010.
While the declining US dollar presents problems longer term for US interest rates there are positive ways to invest with a weaker dollar in mind. Generally a weaker dollar is positive for US equities, especially Large Cap Growth stocks like Apple or Google. Both of these stocks rank very high in our model so they’ve been mainstays this year. In addition, countries and regions that are commodity oriented such as Latin America. Foreign Treasury bonds are another good option and we’ve owned them for most of the year. Gold is another interesting way to prosper from the declining dollar. With the resumption of risk appetites worldwide investors are liquidating dollars and transferring the assets to Gold. Gold also plays a valuable role in the event of a crisis that could erupt in the Middle East should Iran remain contentious regarding its nuclear plans.
All The Best,
Brad Pappas
This week has been a reminder that all is not well with the US economy or the World at large.
Employment data was a bust as economists missed the number by a wide margin. Estimates were for a loss of 175,000 jobs when in fact the reality was 263000 job losses. Hence the Consumer in the US remains a headwind rather than a tailwind.
If you happened to watch the Chris Mathews Show early this week you saw a frightening analysis the Israeli – Iran situation. Both analysts concurred that Israel could take preemptive action within three months. We have scanned portfolios for stocks that could be unusually sensitive should war break out. We’ve sold our position in Internet Gold (IGLD) an Israeli based Internet Service provider. It remains an inexpensive growth name but the risk reward is just not in our favor with this present standoff.
This is not to say that only certain stocks would be vulnerable should a war start in the Middle East. All stocks would be vulnerable should a war erupt as the threat of Iran halting oil exports or Middle East exports in general be prevented would create a spike in oil prices that would place our shallow economic expansion in jeopardy. Massive strength would be seen in Oil and Gold. A lesser hedge wild card could be Alternative Energy / Solar stocks.
While we’re still Bullish…….we’re just not the Red Bulls of the Spring. Short of an all out war in the Middle East we expect any selloff to be shallow and short lived. However the rate and delta of the rally is expected to moderate now that we’re no longer in recession. Thus we continue to slowly reduce our exposure to equities, as we no longer believe the rewards warrant 80% to 100% exposure.
