One of the great things about my role is that I have the opportunity to spend a lot of time with clients throughout the United States. And these days, we have plenty to discuss. The coronavirus outbreak is likely to result in slower global growth and falling corporate profits over the next couple of quarters. Meanwhile, Bernie Sanders is surging in the national polls. Bernie’s bid to top the Democratic ticket in November is raising investors’ worst fears. Mainly, that their treasured business-friendly environment of lower taxes and less burdensome regulations will be snatched from them next year under a progressive Democratic policy agenda.
So far, markets have mostly taken these budding risks in stride. The S&P 500 Index has reached a dozen record highs already this year. Most market watchers expect the negative impacts of the coronavirus to be temporary. Many of those same folks are forecasting a gigantic recovery in the second half of this year to make up for any coronavirus-induced shortfalls during the first six months of 2020. And, despite Sanders’ celebrity, few market participants give the self-described Democratic Socialist much of a chance to dethrone President Trump come November.
Meanwhile, US economic data continues to signal an economy that keeps chugging along. The fourth-quarter earnings season just wrapped up, and results were much better than expected. Finally, the Federal Reserve and other global central banks, most notably the People’s Bank of China, remain firmly committed to keeping markets afloat.
So, what’s not to like about stocks?
Rules Were Meant to Be Broken
Like me, many clients have a strong appreciation for value investing and an unwavering faith in the power of mean reversion. But our collective faith has been shaken during the past decade. Today, alarmingly, several long-established equity relationships have breached extreme levels. As a result, the most common equity questions I get from clients these days are:
- Will US small-cap stocks outperform large-cap stocks?
- When will value stocks finally beat growth stocks?
- Is investing in international developed and emerging markets dead?
For the relative value and mean reversion faithful, US small caps, value stocks, international developed and emerging markets equities are tempting. However, it’s difficult to identify a near-term catalyst for a rebound in their performance. Perhaps I’m dangerously extrapolating the dominant trends of the past decade — US, large-cap, and growth stocks crushing virtually all other investment choices. But like so many relationships in the post-global financial crisis era, small-cap, value and non-US investing seem to have been forever changed by the extraordinary interference of governments and central banks in financial markets.
So, while investors may experience some periods of outperformance from their small-cap, value and non-US investments, it is likely to be short-lived. Without a meaningful shift in economic growth rates, inflation expectations and real interest rates, the dominance of US large-cap growth stocks is poised to continue for a while longer.
Now let’s further examine just how out of whack these equity relationships have become over the past decade.
David Versus Goliath
The most popular US small-cap benchmark, the Russell 2000 Index, hasn’t bested the S&P 500 Index since 2016. In fact, in the past 10 calendar years, small caps have outpaced large caps only four times. Three of those victories occurred during the 2010 to 2013 period, meaning that David has beaten Goliath just once in the last six calendar years. Not surprisingly, investors have voted with their feet. Through February 21, US large-cap ETFs had $19.1 billion in inflows, while US small-cap ETFs suffered $2.1 billion in outflows. Over the past 12 months, US large-cap ETFs have taken in a staggering 17 times more money than US small-cap ETFs.
According to US small-cap guru Steven DeSanctis from Jefferies Group LLC, the five largest stocks in the Russell 1000 Index are now 2.3 times the size of the entire Russell 2000 Index. DeSanctis describes the move as “parabolic.” What’s more, the price-to-sales ratio for the largest five stocks is at its highest level since 2003 and, relative to the Russell 2000 Index, is 103% above its average.
It’s easy to see why these extreme differences between US large and small caps have stoked the curiosity of the mean reversion crowd. However, it may be too early to make the jump into small-cap stocks. At the end of the day, it’s about earnings, and small caps simply don’t have them. About one-third of the Russell 2000 stocks don’t make a profit. Small-cap earnings-per-share fell sharply in 2019, while large caps were able to squeak out a modest gain. US small-cap earnings have trailed large-cap earnings for 12 of the past 13 quarters. This earnings dynamic needs to change before US small caps can retake leadership from large caps.