Posts published in March 2015
Large cap US stocks are barely treading water for the year to date; the S&P 500’s marginally positive return of 0.34% through Thursday’s close derives entirely from dividends. Meanwhile, small cap stocks have opened up a comfortable performance gap relative to their larger cousins. The S&P 600 small cap index is up 2.6% year to date. That’s hardly a barnstorming show of strength, but it does provide a welcome port of call in the generally choppy seas the capital markets have served up this year. Small caps may be in favor for a handful of reasons: comparative immunity from the soaring dollar’s collateral damage and mean-reversion after last year’s underperformance are two popular arguments. Is it too late to reap benefits from a tactical venture into small cap land?
Small Caps and the Dollar
The chart below shows the relative performance trend of large caps and small caps so far this year. The indexes tracked closely for much of this time, but small caps were a bit quicker pulling out of the early March pullback, and went on to chart new record highs while the S&P 500 hit resistance headwinds.
That March time period also coincided with another mini-rally in the dollar. The greenback jumped against the euro in the wake of the March 6 jobs report, bolstering the case that a strong dollar is an established feature of the intermediate term landscape. Since smaller companies on average derive a smaller portion of their revenues from overseas, investors tend to see small caps as less vulnerable to the FX headwinds that have thrown a wet blanket on large companies’ recent earnings reports.
But currency doesn’t seem to be the whole story here. After all, the dollar rallied strongly against most currencies in January, yet, as the above chart shows, small caps were not outperforming then. To understand more of the dynamics at play, we need to break down the small cap universe into its growth and value components. Style trends appear to be a more decisive factor than the currency impact.
In the chart below we see the relative performance of small cap value and growth for the year to date. This shows a style breakout that started well before small caps overall gained the upper hand over large caps.
A simple explanation to the divergence of value and growth styles lies in relative sector exposures. Two of the best-performing sectors for much of this year – healthcare and technology – account for about 35% of the S&P 600 small cap growth. Conversely, over 40% of the small cap value index is made up of financials and industrials, both of which have somewhat lagged the market this year. In fact, the entire small cap vs. large cap outperformance derives from growth stocks; the S&P 600 Value index actually trails the S&P 500 by a small amount year to date.
Bubble, Bubble, Toil and Trouble?
Over the past few days we have seen some jitteriness among names in some of the highest-flying sectors of late, notably biotech. Does this presage an imminent bubble burst? Given the sector exposures we discussed above, a meltdown in key healthcare or technology industries would likely bring a quick end to the growth-driven outperformance gap. On the other hand, there is no particular reason to pin a specific date on the trend reversal, and we’re not yet seeing much data for which value sectors would lead on the reversal’s flip side.
Moreover, while small caps are by no means cheap, a median NTM P/E of 18.6 does not necessarily scream “bubble”. Small caps underperformed large by about 4% on average last year, so a certain amount of mean reversion is likely baked into the current trend. On balance, we continue to see a reasonable case for maintaining a tactical overlay in small caps, with a more or less neutral balance between value and growth.
It’s still a Fed market. The Kabuki drama that is the two-day Fed Open Market Committee conclave raised itself to new heights of artfulness this week. In her best imitation of a photon being a wave and a particle at the same time, Janet Yellen maintained that the Fed can be patient without actually being…well…patient. And assets did what assets do: follow the Fed. Stocks, bonds and any currency not called the US dollar soared back into the heavenly realms on Wednesday after the white smoke emerged from the Eccles Building. There was a bit of second-guessing on Thursday as markets gave up some of those heady gains. But by Friday morning everything was right as rain again. The S&P 500 is closing back in on its March 2 all-time high, 10-year yields remain below 2%, and for now it seems that the extraordinary times continue.
The Veiled and the Seen
The Fed’s mandate is to direct its monetary policy towards the dual objectives of maximum employment and stable prices. Would a 25 or 50 basis point increase in the Fed funds rate really be directly counterproductive and harmful to those goals? That seemed to be the intent of the 3/18 communiqué’s hard-hitting first paragraph: economic growth has moderated, household spending is likewise moderate, housing is slow and exports are weak. Yes, we are on the right course, but it still may take time. Just look at where inflation is now, relative to our 2% target. Look at below-trend market-based compensation measures. Look at slowness in the housing market. Those data points imply “patient” so that we don’t actually have to say it.
All of which is laudably transparent, as far as it goes. And there is nothing wrong with, as the communiqué notes, taking into account current market trends such as export weakness and “international developments”, a somewhat veiled reference to the dollar’s dominance over almost all other currencies in the foreign exchange market. What is concerning is the notion that Fed policy would be directly reactive to asset market trends. Prolonging the low rate environment as the best way to achieve the Fed’s dual mandate is fine; prolonging zero rates to specifically jawbone down the dollar is not fine. There is a nuance there, but it is an important one. Targeting specific asset market outcomes in pursuit of policy is tantamount to market manipulation, which is the opposite of transparent. It provides fodder to the many cynics who have long argued the Fed is doing just that.
Tail, Meet Dog
It also signals a lack of confidence; forming policy in reaction to changing market events is the tail wagging the dog. The Fed should not have a near-term target number in mind for the dollar, or the S&P 500, or even the 10-year Treasury. That is beyond the scope of its mandate. If the policy prescription is correct, then eventually the wisdom of the policy should manifest itself in economic data and asset prices alike. Let markets be markets.
The non-cynical way to look at Wednesday’s communiqué and briefing is to applaud the Fed for freeing itself of the “patient” language without roiling markets. That deft linguistic sleight of hand could actually make it easier for the FOMC to act sooner, even in June, if wage growth and prices perk up enough between now and then. But the chains remain. Short-term hissy fits surely continue to lurk under the surface, waiting for a sign that the rate hike is nigh. The right thing to do, when the time comes, would be to fire away and let the babies have their (probably short-lived) tantrum. That would convey real confidence, and we believe markets would recognize it as such.
Paris, Je T’Aime
There seems to be no end to the euro’s woes. The Old Continent’s currency has fallen 25% against the dollar from its high mark last summer, and is closing in on parity. That’s good news for tourists dreaming of springtime in Paris; somewhat more surprisingly, it has also been a boon for Eurozone equities. The MSCI Euro Index, which tracks the home equity markets of the single currency region, is up 2.6% for the year to date as of the 3/12 close, versus 0.8% for the S&P 500. That’s 2.6% in US dollar terms, mind you. In home currency terms the Euro Index is up a whopping 17.0%. The combination of Euro-style QE (launched this week) and somewhat better-than-expected headline economic news appears capable of more than offsetting the drag caused by the plummeting currency.
Rising Sun, Rising Stocks
Japanese shares are also enjoying a season of growth. The yen is down 18% from its twelve month high, but the MSCI Japan Index is up 8.5% for the year to date (again, as measured in dollar terms). This despite an economy where retail sales tanked in the wake of last year’s consumption tax hike and where stagnation has been the default mode for the better part of the last two decades. Prime Minister Shinzo Abe’s “three arrows” of economic stimulus have yet to offer definitive proof that they’re working, but investors appear disinclined to wait around.
Diversification Is Your Friend Again
The go-go performance of Eurozone and Japanese equities contrasts starkly with the moribund performance of US stocks year to date. For the past three years US large caps have been dominant. Asset managers who – in keeping with prudent practices for long term investing – have managed diversified portfolios have been punished for nearly every dollar of non-US exposure during this time. The MSCI EAFE Index, a composite of developed markets in Europe, Australasia and the Far East, gained a scant 5.8% on an average annual basis over the past three years. For the same period the S&P 500 index of large cap US stocks boasted a 17.2% average annual gain. So in addition to the underlying currency and economic factors, this year’s relative performance would serve as a useful reminder that mean reversion lives. Every dog has its day, and every day has its dog.
Earnings and FX Headwinds
Weak currencies can be good for shares because, all else being equal, they make companies’ exports more competitive on the world markets. Both the Eurozone and Japan are traditionally high value-added exporters. Companies as diverse as Toyota and Moncler (an Italian producer of high-end luxury winter coats) have benefitted mightily from the respective plights of their home currencies. One imagines an uptick in the number of Italian and French luxury coats spotted in the New York Times Style section. Conversely, Europe’s and Japan’s tailwind is a daunting headwind for large US companies which derive a significant portion of their sales from overseas.
While we see continued opportunities for tactical positioning in European and Japanese equities, we are far from convinced of any sustainable outperformance over time. Both regions continue to face profound economic challenges, ones not likely to be resolved simply by waves of the QE magic wand. The year is far from over.
March 15 – the Ides – falls a week from this coming Sunday. But this year it’s actually two days after the ancient Roman feast of Lupercalia (and anniversary of the death of Julius Caesar) that has the soothsayers buzzing. That’s when the Fed convenes for its next policy session, armed with the latest jobs data released earlier this morning. The hills and dales of the Twitterverse are alive with the sound of Fedwatchers: will they or won’t they? How many synonyms for “patient” exist in the English language? Is the labor market really Schrödinger’s Cat in disguise: tight (5.5% unemployment) and slack (near-zero wage growth) at the same time? How these questions play out in the days leading up to and then beyond the March 17-18 meeting will likely have a meaningful impact on the near term course of stocks and rates.
Strong Growth, No Growth
It is always interesting to follow the chatter after the monthly BLS jobs release: which data point will “win the day” and become the focal point of the conversation? Today’s release served up a very impressive headline number: the overall unemployment rate fell to 5.5% and nonfarm payrolls added 295,000 jobs. That’s twelve straight months of job creation above 200,000. The past four months represent the fastest pace of jobs growth since the late 1990s.
What looks nothing like the late ‘90s, though, is the persistently tepid pace of wage growth. One month ago we got a brief glimpse of a green shoot here, with average wages growing 12 cents month-to-month at the end of January. That green shoot appears to have been buried by the latest snowstorm though; wage growth was basically flat for February and in line with the year-on-year pace of 2% that has been the norm for a while.
So which is it, strong growth or no growth? Remember that there was a time, not too long ago, when Fed guidance on rates focused on crossing the unemployment threshold of 6.5%. Obviously that threshold has long since come and gone. What has stayed the Fed’s hand has been softness in prices generally and wages in particular. This month’s data fail to serve up a conclusive take on what the Fed will be inclined to do come mid-month. But one view is coming in loud and clear: yields on the 10-year have jumped 11 basis points since the jobs data release.
What is happening on the yield curve today is, in fact, somewhat counterintuitive. The spike in the 10-year yield is of a larger magnitude than movements in the 2-year yield, which as a short term rate is more directly impacted by Fed rate policy. The general consensus among bond market watchers has called for a continued flattening of the curve, with short term rates rising in anticipation of the Fed, while ongoing foreign demand for intermediate- and long-dated issues keeps a lid on yields down-curve. We think it likelier than not that today’s curve trades are more noise than signal. With Eurozone QE firing up and foreign currencies plumbing new lows against the dollar, there should be plenty of continuing appetite for Uncle Sam’s debt obligations.
Equities are also trending negative today, so stocks and bonds alike seem to be listening to the soothsayers and fearing what comes after the Ides. But, as we have said here time and again, in the long run growth should trump rates. We’ll take Fed action – whether a simple removal of “patient” from the lexicon or more decisive guidance on timing – as another signpost on the road towards growth and a reason to stay fully invested in equities.