One of my all time favorite movies is Gosford Park which is a complex murder mystery set in a grand manor house in Britain in between the first and second world wars. The movie was scripted by Julian Fellows and directed by Robert Altman and laid the foundation for Downtun Abbey
There is a scene between a passively scathing Constance, the Countess of Trentham (played by Maggie Smith) a failing silent film star Ivor Novello (played by Jeremy Northam):
Constance: “Tell me….how much longer are you going to go on making films?”
Ivor: “I suppose that rather depends on how much longer the public want to me in them.”
Constance:”It must be hard to know when its time to throw in the towel….What a pity about the last one of yours…what was it called? “The Dodger”?
Ivor:”The Lodger”
Constance: “It must be so disappointing when something just “flops” like that”?
Ouch….
Alas, now that the small caps have “flopped” in 2014 we have likely reached the tipping point where we must bid adieu to micro, small and mid cap stocks otherwise remaining will likely be akin to Ivor’s box office busts. And the rationale is quite clear:
We have reached the point in the economic cycle where both the current market rally and economic expansion are quite mature…perhaps as late as the 7th inning. Investors are no longer looking to the Federal Reserve to maintain its massive liquidity supply as the Fed has openly stated that they will be targeting the Fed Funds rate to 1.5% by late 2015, hence our eyes are looking to the endgame of the expansion and rally.
Micro, small and mid-cap stocks are frequently among the first market sectors to decline in anticipation of a recession or bear market. Even though the bear market/recession may be years away, just the knowledge of its inevitability will cause investors to migrate to Large Cap stocks and likely remain there until the final signs of a recession are visible. Hence I don’t anticipate our returning to small stocks until after the next recession.
Employment levels are the key for the Fed and based on current projections by the first half of 2015 we can expect the Fed to begin a slow and gradual series of rate hikes. But as always, markets anticipate the future well ahead of the actual event and the weakness in the micro, small and even mid cap markets is reminiscent of the last “late cycle” of 2006-2008. In 2006, despite the recession being two years away small stocks began a noticeable lag compared to large caps.
Please take a look at the chart below (1995 to 2014) which identifies which months tend to be the best and worst for small stocks ($RUT) compared to large stocks ($SPX). You’ll obviously notice that October is the worst month while November and December are the best.
Now lets examine two “late cycle” periods: 1998 to 2000. You’ll notice that 8 months in the calendar year the small cap Russell 2000 lagged the S&P 500. And, in the months of March and October there were zero cases where the Russell 2000 excelled.
Our second example is 2007 to 2008: A similar pattern emerges where the Russell 2000 outperforms the S&P 500 only three months of the year.
Now lets take a look at the last 5 years from 2010 to 2014: The relative performance is 180 degrees in reverse, its been a wonderful ride but with the onset of rate hikes the continuation is likely doomed.
By this point I’m sure that you’re ready to ask: “What will work in the late cycle environment”?
As always, we are agnostic to markets whether they be micro, small or large or even if we should be invested in stocks at all. 2006 and 2007 are not so long ago that we can recall what worked and use those methods again. We have already integrated these systems into accounts over $250,000 and will continue to periodically sell off small and micro cap holdings. We still have time on our side since none of our long lead indicators are giving advance notice of an incoming recession. While I said earlier that we could be in the 7th inning, we could also go into extra innings which would push a recession past 2017. Regardless based on the data it appears likely that the small cap run is over. Long live the large cap run!
What works?
The graphs shown below are hypothetical backtests and not real time examples. Real time results will vary and the returns shown in this example cannot be extrapolated to real time investing in the future. As always, past performance is no assurance of future performance nor may it even be profitable going forward. But as Mark Twain said: “History doesn’t repeat itself but it does rhyme.”
Our version of the Joel Greenblatt’s “Magic Formula” for starters. Its exclusively large cap-centric and easily adaptable for socially responsible investors and Vegan investors. We’ve eliminated owning financial stocks in the system which gives a boost to performance.
Secondly, our own proprietary large cap system. This system is 93% large caps and 7% mid caps and has a socially responsible and a Vegan screen installed.
And now for something in real-time: Back in 2007 we had quite a good year. Our strategy then was Large Cap Technology stocks. The names you’re all familiar with: Google, Apple, Research In Motion (R.I.P), Nokia, etc. As growth across the world begins to falter with impending rate hikes investors flock to reliable growth and Big Tech appears to be working its magic again in 2014. In this case the cycle is not just rhyming but it may be repeating.
In 2007 we did not have the luxury or safety of owning a basket of Big Tech in a single Exchange Traded Fund (ETF). But we do now and it makes a great deal of sense in this case of owning the ETF rather than the individual stocks.
Case in point for growth oriented investors: Direxion Technology Bull 3x.
If you look at the chart below you’ll see that the TECL has been leaving the small cap ETF “IWM” and the S&P 500 in the dust for the past 12 months. Our best guess is that this trend will continue and we plan to make it a core holding.
Long TECL