The recent market volatility – the tale of the perfect storm

The recent market volatility – the tale of the perfect storm

The recent market volatility – the tale of the perfect storm

October is traditionally a rough month for stocks. And October 2018 proved it.

S&P 500 went down -6.9% in October after gaining as much as 10.37% in the first nine months of the year. Despite recouping some its losses in early November, the market continues to be volatile with large daily swings in both directions. On top of that, Small Cap stocks which were leading the way till late September went down almost 10% in the span of a few weeks.

So what lead to this rout?

The market outlook in September was very positive. Consumer sentiment and business optimism were at a record high. Unemployment hit a record low. And the market didn’t really worry about tariffs.

I compiled a list of factors which had a meaningful impact on the recent market volatility. As the headline suggested, I don’t believe there was a single catalyst that drove the market down but a sequence of events creating a perfect storm for the equities to go down.

IndexQ1 2018Q2 2018Q3 2018Q3 YTD 2018Oct – Nov 2018Nov 2018 YTD
S&P 500 Large-Cap (SPY)-1.00%3.55%7.65%10.37%-4.91%5.45%
S&P 600 Small-Cap (IJR)0.57%8.69%4.87%14.64%-9.54%5.09%
MSCI EAFE (VEA)-0.90%-1.96%1.23%-1.62%-7.06%-8.68%
Barclays US Aggregate Bond (AGG)-1.47%-0.18%-0.08%-1.73%-0.81%-2.54%
Gold (GLD)1.73%-5.68%-4.96%-8.81%1.39%-7.42%
Source: Morningstar

1. Share buybacks

The month of October is earnings season. Companies are not allowed to buy back shares as they announce their earnings. The rationale is that they possess significant insider information that could influence the market in each direction. As it turned out, 2018 was a big year for share buybacks. Earlier in the year, S&P estimated $1 trillion worth of share buybacks to be returned to shareholders. So, in October, the market lost a big buyer – the companies who were buying their own shares. And no one stepped in to take their place.

The explosion of share buyback was prompted by the TCJA law last year which lowered the tax rate of US companies from 35% to 21%. Additionally, the new law imposed a one-time tax on pre-2018 profits of foreign affiliates at rates of 15.5% for cash and 8% for non-cash assets. Within a few months, many US mega-cap corporations brought billions of cash from overseas and became buyers of their stock.

2. High valuations

With the bull market is going on its ninth year, equity valuations remain high even after the October market selloff.

Currently, the S&P 500 is trading at 22.2, above the average level of 15.7. Its dividend yield is 1.9%, well below the historical average of 4.34%.

Furthermore, the current Shiller PE Ratio stands at 30.73, one of the highest levels in history. While the traditional Price to Earnings ratio is calculated based on current or estimated earning levels, the Schiller ratio calculates average inflation-adjusted earnings from the previous ten years. The ratio is also known as the Cyclically Adjusted PE Ratio (CAPE Ratio) or PE10.

Current Shiller PE Ratio: 2:00 PM EST, Tue Nov 13
Current Shiller PE Ratio:
2:00 PM EST, Tue Nov 13
Source: https://www.multpl.com/shiller-pe/ 

While a coordinated global growth and low-interest rate environment had previously supported the thesis that high valuation ratios were justified, this may not be the case for much longer.

3. The divergence between US and international stocks

The performance of International Developed and Emerging Market remains disappointing. While the US markets are still in positive territory, International Developed and EM stocks have plunged by -8% and -15% respectively so far in 2018.  Higher tariffs imposed by the US, negative Brexit news, growing domestic debt in China, and slower GDP growth in both the Eurozone and China have spurred fears of an upcoming recession. Despite attractive valuations, international markets remain in correction territory, The dividend yield of MSCI EAFE is 3.34%, while MSCI EM is paying 2.5%, both higher than 1.9% for S&P 500.

4. The gap between growth and value stocks

The performance gap between growth and value stocks is still huge. Growths stocks like Apple, Amazon, Google, Visa, MasterCard, UnitedHealth, Boeing, Nvidia, Adobe, Salesforce, and Netflix have delivered 10% return so far this year. At the same time value strategies dominated by Financials, Consumer Staples and Energy companies are barely breaking even.

IndexQ1 2018Q2 2018Q3 2018Q3 YTD 2018Oct – Nov 2018Nov 2018 YTD P/E Ratio
S&P 500 Large Cap Growth (IVW)1.81%5.17%9.25%16.97%-6.95%10.01%29.90
S&P 500 Large Cap Value (IVE)-3.53%1.38%5.80%3.26%-2.59%0.67%19.44

 

5. Tempering earnings growth

So far in Q3 2018, 90% of the companies have announced earnings. 78% of them have reported better than expected actual earnings with an average earnings growth rate of 25.2%. 61% of the companies have reported a positive sales surprise. However, 58 companies in the S&P 500 (12%) have issued negative earnings guidance for Q4 2018. And the list of stocks that tumbled due to cautious outlook keeps growing – JP Morgan, Facebook, Home Depot, Sysco, DR Horton, United Rentals, Texas Instruments, Carvana, Zillow, Shake Shack, Skyworks Solutions, Michael Kors, Oracle, GE, Cerner, Activision, etc.

Despite the high consumer optimism and growing earnings, most companies’ CFOs are taking a defensive approach. Business investment grew at a 0.8% annual rate in the third quarter, down from 8.7% in the second quarter. This was the slowest pace since the fourth quarter of 2016.

The investment bank Nomura also came out with the forecast expecting global growth to slow down. Their economists predicted that global growth in 2019 would hit 3.7% and temper to 3.5% in 2020 from 3.9% in 2018. According to Nomura, the drivers for the slowdown include waning fiscal stimulus in the U.S., tighter monetary policy from the Federal Reserve, increased supply constraints and elevated risk of a partial government shutdown.

 

6. Inflation is creeping up

Almost a decade since the Credit Crisis in 2008-2009, inflation has been hovering below 2%. However, in 2018, the inflation has finally made a comeback. In September 2018, monthly inflation was 2.3% down from 2.9% in July and 2.7% in August.

One winner of the higher prices is the consumer staples like Procter & Gamble, Unilever, and Kimberly-Clark. Most of these companies took advantage of higher consumer confidence and rising wages to pass the cost of higher commodity prices to their customers.

7. Higher interests are starting to bite

After years of near-zero levels, interest rates are starting to go higher. 10-year treasury rate reached 3.2%, while the 2-year rate is slowly approaching the 3% level. While savers are finally beginning to receive a decent interest on their cash, CDs and saving accounts, higher interest rates will hurt other areas of the economy.

10 year versus 2 year treasury rate

With household debt approaching $13.4 trillion, borrowers will pay higher interest for home, auto and student loans and credit card debt. At the same time, US government debt is approaching $1.4 trillion. Soon, the US government will pay more for interest than it is spending on the military.  The total annual interest payment will hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office.

The higher interest rates are hurting the Financial sectors. Most big banks have enjoyed a long period of paying almost nothing on their client deposits and savings accounts. The rising interest rates though have increased the competition from smaller banks and online competitors offering attractive rates to their customers.

We are also monitoring the spread between 2 and 10-year treasury note, which is coming very close together. The scenario when two-year interest rates go above ten-year rates causes an inverted yield curve, which has often signaled an upcoming recession.

8. The housing market is slowing down

Both existing and new home sales have come down this year.  Rising interest rates, higher cost of materials, labor shortage and high real estate prices in major urban areas have led to a housing market slow down. Existing home sales dropped 3.4% in September coming down for six months in a row this year. New building permits are down 5.5% over 2017.

Markets have taken a negative view on the housing market. As a result, most homebuilders are trading at a 52-week low.

9. Fear of trade war

Some 33% of the public companies have mentioned tariffs in their earnings announcements in Q3. 9% of them have negatively mentioned tariffs. According to the chart below, Industrials, Information Technology, Consumer Dictionary, and Materials are the leading sectors showing some level of concern about tariffs.

Companies Citing Tariffs Compared to Q2 2018

10. Strong dollar

Fed’s hiking of interest rates in the US has not been matched by its counterparts in the Eurozone, the UK, and Japan. The German 10-year bund now yields 0.4%, while Japanese 10-year government bond pays 0.11%. Combining the higher rates with negative Brexit talks, Italian budget crisis and trade war fears have led to a strong US dollar reaching a 17-month high versus other major currencies.

Given that 40% of S&P 500 companies’ revenue comes from foreign countries, the strong dollar is making Americans goods and services more expensive and less competitive abroad. Furthermore, US companies generating earnings in foreign currency will report lower US-dollar denominated numbers.

11. Consumer debt is at a record high

The US consumer debt is reaching 4 trillion dollars. Consumer debt includes non-mortgage debts such as credit cards, personal loans, auto loans, and student loans. Student loans are equal to $1.5 trillion while auto debt is $1.1 trillion and credit card debt is close to $1.05 trillion. Furthermore, the US housing dent also hit a record high. In June, the combined mortgage and home equity debt were equal to $9.43 trillion, according to the NY Fed.

The rising debt has been supported by low delinquencies, high property values, rising wages, and low unemployment. However, a slowdown in the economy and the increasing inflation and interest rates can hurt US consumer spending.

12. High Yield and BBB-rated debt is growing

The size of the US corporate debt market has reached $7.5 trillion. The size of the BBB rated debt now exceeds 50% of the entire investment grade market. The BBB-rated debt is just one notch above junk status. Bloomberg explains that, in 2000, when BBB bonds were a mere third of the market, net leverage (total debt minus cash and short-term investments divided by earnings before interest, taxes, depreciation, and amortization) was 1.7 times. By the end of last year, the ratio had ballooned to 2.9 times. Source: Bloomberg

Further on, the bond powerhouse PIMCO commented: “This suggests a greater tolerance from the credit rating agencies for higher leverage, which in turn warrants extra caution when investing in lower-rated IG names, especially in sectors where earnings are more closely tied to the business cycle.”

13. Oil remains volatile

After reaching $74.15 per barrel in October, US crude oil tumbled to $55, a 24% drop. While lower crude prices are pushing down on inflation, they are hurting energy companies, which are already trading in value territory.

According to WSJ, the oil’s rapid decline is fueling fears for global oversupply and slowing economic growth. Furthermore, the outlook for supply and demand shifted last month as top oil producers, began ramping up output to offset the expected drop in Iranian exports. However, earlier this month Washington decided to soften its sanctions on Iran and grant waivers to some buyers of Iranian crude—driving oil prices down. Another factor pushing down on oil was the strong dollar.

14. Global political uncertainty

The Brexit negotiations, Italian budget crisis, Trump’s threats to pull out of WTO, the EU immigrant crisis, higher tariffs, new elections in Brazil, Malaysian corruption scandal and alleged Saudi Arabia killing of a journalist have kept the global markets on their toes. Foreign markets have underperformed the US since the beginning of the year with no sign of hope coming soon.

15. The US Election results

A lot has been said about the US elections results, so I will not dig in further. In the next two year, we will have a divided Congress. The Democrats will control the house, while the Republicans will control the Senate and the executive branch. The initial market reaction was positive. Most investors are predicting a gridlock with no major legislature until 2020. Furthermore, we could have intense budget negotiations and even another government shutdown. Few potential areas where parties could try to work together are infrastructure and healthcare. However, any bi-partisan efforts might be clouded by the upcoming presidential elections and Mueller investigation results.

In Conclusion

There is never a right time to get in the market, start investing and saving for retirement. While market volatility will continue to prevail the news, there is also an opportunity for diligent investors to capitalize on their long-term view and patience. For these investors, it is essential to diversify and rebalance your portfolio.

In the near term, consumer confidence in the economy remains strong. Rising wages and low unemployment will drive consumer spending. My prediction is that we will see a record high shopping season. Many of these fifteen headwinds will remain. Some will soften while others will stay in the headlines.

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

Market Outlook October 2018

Overview

The US stock market was on an absolute tear this summer. S&P 500 went up by 7.65% and completed its best 3rd quarter since 2013. Despite the February correction, the US stocks managed to recover from the 10% drop. All major indices reached a series of record highs at the end of August and September.

IndexQ1 2018Q2 2018Q3 2018YTD 2018
S&P 500 Large-Cap (SPY)-1.00%3.55%7.65%10.37%
S&P 600 Small-Cap (IJR)0.57%8.69%4.87%14.64%
MSCI EAFE (VEA)-0.90%-1.96%1.23%-1.62%
Barclays US Aggregate Bond (AGG)-1.47%-0.18%-0.08%-1.73%
Gold (GLD)1.73%-5.68%-4.96%-8.81%
Source: Morningstar

 

The US Economy remains strong

Markets have largely shrugged off the trade war fears benefiting from a strong economy and high corporate earnings.

US Unemployment remains low at 3.9% in July and August, levels not seen since the late 1960s and 2000.

Consumer sentiment is at a multi-year high. The University of Michigan Consumer Sentiment Index hit 100.1 in September, passing 100 for the third time since the January of 2004.

Business optimism hit another record high in August.  The National Federation of Independent Business’ small business optimism index reached the highest level in the survey’s 45-year history. According to NFIB, small business owners are planning to hire more workers, raise compensation for current employees, add inventory, and spend more on capital investments.

A hypothetical 60/40 portfolio

A hypothetical 60/40 index portfolio consisting of 30% US Large Cap Stocks, 10% US Small Cap Stocks, 20% International Stocks, 33% US Fixed Income and 7% Gold would have returned 3.06% by the end of September.

IndexAllocationReturn
S&P 50030%3.11%
S&P 60010%1.46%
MSCI EAFE20%-0.32%
Barclays USAgg Bond33%-0.57%
Gold7%-0.62%
Hypothetical Performance3.06%

 

US Equity

I expect a strong Q4 of 2018 with a record high holiday consumer and business spending. While stock valuations remain elevated, robust revenue and consumer demand will continue to drive economic growth.

After lagging large-cap stocks in 2017, small-cap stocks are having a comeback in 2018. Many domestically focused publicly traded businesses benefited massively from the recent corporate tax cuts, higher taxes on imported goods and healthy domestic demand.

This year’s rally was primarily driven by Technology, Healthcare and Consumer Discretionary stocks, up 20.8%, 16.7%, and 13.7% respectively. However, other sectors like Materials, Real Estate, Consumer Staples, Financials and Utilities are either flat or negative for the year. Keep in mind of the recent reshuffle in the sector classification where Google, Facebook, Netflix and Twitter along with the old telecommunication stocks were added to a new sector called Communication services.

Sector performance

SectorPerformancePrice perPrice toDividend
YTDEarningsSalesYield
as of 10/3/2018(TTM) (TTM)(%)
Communication Services-1.91%22.6x1.3x4.83%
Consumer Discretionary13.72%16.5x1.0x1.27%
Consumer Staples-5.50%15.1x1.0x2.86%
Energy8.67%14.0x1.2x1.74%
Financials0.29%15.2x2.1x1.91%
Health Care16.71%18.2x1.2x1.86%
Industrials4.73%15.7x1.1x1.85%
Information Technology20.86%14.8x2.1x0.90%
Materials-3.56%13.2x1.1x1.79%
Utilities0.77%17.1x1.3x3.70%
Source: Bloomberg

 

I believe that we are in the last few innings of the longest bull market. However, a wide range of sectors and companies that have largely remained on the sidelines. Some of them could potentially benefit from the continued economic growth and low tax rates.

International Equity

The performance gap between US and foreign stocks continues to grow. After a negative Q1 and Q2, foreign stocks recouped some of the losses in Q3. Furthermore, emerging market stocks are down close to -9% for the year.

Bad economic data coming from Turkey, Italy, Argentina, Brazil, Indonesia, South Africa, and China along with trade war fears put downward pressure on foreign equity markets. Additionally, rising right-wing sentiments in Italy, Austria, Sweden, Hungary, and even Germany puts doubts on the stability of the European Union and its pro-immigration policies.

In my view, the risk that the financial crisis in Turkey, Argentina, and Italy will spread to other countries is somewhat limited. However, the short-term headwinds remain, and we will continue to monitor these markets.

Brexit

Another major headline for European stocks is the progress of the Brexit negotiation. While soft Brexit would benefit both sides, a hard exit could have a higher negative impact on the UK.

I remain cautiously positive on international stocks. According to WSJ, foreign stocks are trading at a 12% discount over US equity on price to earnings basis. This year created value opportunities in several counters. However, the issue with European and Japanese stocks is not so much in valuations but the search for growth catalysts in conservative economies with an aging population.

Fixed Income

Rising Fed rates and higher inflation have driven bond prices lower so far this year. With inflation rate hovering at 2%, strong employment figures, rising commodity cost, and robust GDP growth, the Fed will continue to hike interest rates. I am expecting one more rate hike in December and three additional hikes in 2019.

I will also continue to monitor the spread between 2-year and 10-year treasury. This spread is currently at 0.23%, the lowest level since 2005.  Normally, a negative spread, i..e 2-year treasury rare higher than 10-year is a sign of a troubled economy.

While modest, individual pockets of the fixed-income market are generating positive performance this year. For instance, short duration fixed income products are now yielding in the range of 1.5% to 2%. The higher interest is now a compelling reason for many investors to keep some of their holdings in cash, CDs or short-term instruments.

With 10-year treasury closing above 3% and moving higher, fixed income investors will continue to see soft returns on their portfolio.

Gold

Gold is one of the big market losers this year. The strong dollar and robust US economy have led to the precious metal sell-off.  While the rise cryptocurrency might have reduced some of the popularity of Gold, I still believe that a small position in Gold can offer a buffer and reduce the overall long-term portfolio volatility. The investors tend to shift to Gold during times of uncertainty.

Navigating market highs

With S&P 500, NASDAQ and Dow Jones hitting all-time highs, how should investors manage their portfolio?

Rebalance

End of the year is an excellent opportunity for reconciliation and rebalancing to your target asset allocation. S&P 500 has returned 16.65% in the past five years, and the chance that equities are taking a big chunk of your portfolio is very high. Realizing some long-term gains and reinvesting your proceeds into other asset classes will ensure that your portfolio is reset to your desired risk tolerance level as well as adequately diversified.

Think long-term

In late January and early February, we experienced a market sell-offs while S&P 500 dropped more than 10%. Investors in the index who did not panic and sold at the bottom recouped their losses and ended up with 10% return as of September 30, 2018. Taking a long-term view will help you avoid the stress during market downturns and allow you to have a durable long-term strategy

 

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

Market Outlook April 2018

Market Outlook April 2018

Market Outlook April 2018

After a record high 2017, the volatility has finally returned. Last year the market experienced one of the highest risk-adjusted performances in recent history. In 2017 there were only 10 trading where the S&P 500 moved by more than 1% in either direction, with not a single trading day when it moved by more than 2%. In contrast, in the 61 trading days of Q1 of 2018, we had 26 days when the S&P 500 moved by more than 1% and 8 days where it changed by more than 2%.

Learn more about our Private Wealth Management services

 

VIX Index Q1 2018

Market Outlook April 2018
VIX index Q1 2018. Source Yahoo Finance

The VIX Index, which measures the volatility of the S&P 500 started the year ar 9.77. It peaked at 37.33 and ended the quarter at 19.97.

Markets do not like uncertainty, and so far, Q1 had plenty of that. In the first 3 months of the year market landscape was dominated by news about rising inflation and higher interest rates, the Toys R Us bankruptcy, trade war talks and tariffs against China, and scandals related to Facebook user data privacy.

Except for Gold, all major market indices finished in the negative territory.

IndexQ1 2018
S&P 500-1.00%
Russell 2000-0.18%
MSCI EAFE-0.90%
Barclays US Aggregate Bond Index-1.47%
Gold+1.73%

 

Fixed Income

Traditionally bonds have served as an anchor for equity markets. Over time stocks and US Treasury bond have shown a negative correlation. Usually, bonds would rise when stocks prices are falling as investors are moving to safer investments. However, in 2018 we observed a weakening of this relationship. There were numerous trading days when stocks and bonds were moving in the same direction.

On the other hand, despite rising interest rates, we see the lowest 10-year/2-year treasury spread since the October of 2007. The spread between the two treasury maturities was 0.47 as of March 29, 2018. While not definite, historically negative or flat spreads have preceded an economic recession.

Momentum

Momentum remained one of the most successful strategies of 2018 and reported +2.97%. Currently, this strategy is dominated by Technology, Financials, Industrials, and Consumer Cyclical stocks. Some of the big names include Microsoft, JP Morgan, Amazon, Intel, Bank of America, Boeing, CISCO, and Mastercard.

Value

Value stocks continued to disappoint and reported -3.73% return in the Q1 of 2018. Some of the biggest names in this strategy like Exxon Mobile, Wells Fargo, AT&T, Chevron, Verizon, Citigroup, Johnson & Johnson, DowDuPont and Wall-Mart fell close to or more than -10%. As many of these companies are high dividend payers, rising interest rates have decreased the interest of income-seeking investors in this segment of the market.

Small Cap

As small-cap stocks stayed on the sideline of the last year’s market rally, they were mostly unaffected by the recent market volatility.  Given that most small-cap stocks derive their revenue domestically, we expect them to benefit significantly from the lower tax rates and intensified trade war concerns.

Gold

Gold remained a solid investment choice in the Q1 of 2018. It was one of the few asset classes that reported modest gains. If the market continues to b volatile, we anticipate more upside potential for Gold.

 

Outlook

  • We anticipate that the market volatility will continue in the second quarter until many of the above issues get some level of clarification or resolution.
  • We expect that small and large-cap stocks with a strong domestic focus to benefit from the trade tariffs tension with China and other international partners
  • The actual impact of lower taxes on corporate earnings will be revealed in the second half of 2018 as Q3 and Q4 earnings will provide a clear picture of earnings net of accounting and tax adjustments.
  • Strong corporate earnings and revenue growth have the ability to decrease the current market volatility. However, weaker than expected earnings can have a dramatically opposite effect and drive down the already unstable markets.
  • If the Fed continues to hike their short-term lending rates and inflation rises permanently above 2%, we could see a further decline in bond prices.
  • Our strategy is to remain diversified across asset classes and focus on long-term risk-adjusted performance

 

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

 

Will Small Caps continue to rally under Trump Presidency?

Small Cap stocks are a long-time favorite of many individual investors and portfolio manager. The asset class jumped 38% since the last election. Will Small Caps continue to rally under Trump Presidency? Can they maintain their momentum?

The new president Trump started with promises for domestic business growth, lower taxes, and deregulation. While details are still unclear, if implemented correctly, these policies can bring significant benefits to small size companies.

The recent growth comes after five years of sluggish performance. Before the 2016 election, the Russell 2000 had underperformed S&P 500 500 by almost 2% annually, 11.59% versus 13.44%.  Small-cap stocks have been very volatile and fragmented. As a result, many active managers have underperformed passive index strategies.

 

Low tax rates

The average US corporate tax rate is 39.1% which includes 35% federal tax and 4.1% average state tax. USA has the highest corporate tax among OECD countries, which have an average of 29% tax rate. While large multinationals with their corporate lawyers can take advantage of cross-border tax loopholes, the same is not possible for smaller businesses. Dropping the tax rate to the suggested 20% will give small caps a breath of fresh air. It will allow them to have more available cash, which they can use for hiring more talent, R&D or dividends.

Deregulation

Regulations are typically set to protect the consumer and the environment from businesses which prioritize profit margins over safety. Therefore, lifting regulations will be a tricky game. If the streamlining leads to more competition, better customer experience, less bureaucracy, and faster processing of business requests to governing bodies, then deregulation will help smaller business thrive further and be more competitive.

 Infrastructure

I drive a lot around the San Francisco Bay Area and can ensure you that every highway with “80” in the name is in dire need of major TLC. The same story is probably true for many major cities and industrial centers. If the executed correctly, the infrastructure policy can boost small business growth. Local companies can bid for infrastructure projects or participate as subcontractors. Improved infrastructure can also help goods and produce to arrive faster and safer and ultimately drive down cost.

Domestic production incentives

With the current strong dollar and liberal trading policy, the small business has struggled to compete against imports, which rely heavily on cheap labor and often on local government subsidies. Certain industries like textile and electronics are almost non-existent in the US.

Nevertheless, I think setting embargos and trade wars with other countries will be a step in the wrong direction. Alternatively, The US government should support industries that offer innovative, high quality, customized and niche products, which can dominate the global markets.

 

While the markets are currently optimistic about the success of the new economic policies, things can still go wrong. The markets had a long rally since the end of the bear market in March 2009. At the current level, both large and small-cap companies have reached rich valuations, and stock prices are factoring the proposed economic policies. The stock market may react abruptly if the new administration fails to deliver their promises.

Some of the side effects of the new policies need to be in consideration as well.

Rising interest rates

The 10-year Treasury jumped from 1.5% in July 2016 to 2.47% today. While high-interest rates have been welcomed by many market players, they can hurt the small business’ ability to get new loans. Many companies rely on external financing to fund their daily business activities, R&D, and expansions. Higher interest rates will increase the cost and affect the bottom line of those companies that traditionally use loans as part of their business and have less access to internal resources.

Another caveat in this topic is the proposed change to eliminate the interest as a tax deduction. While still up-in-the-air, this proposal will further affect those companies that depend on external loans for financing.

Inflation

Inflation is healthy for the economy when it’s a result of organic economic growth, innovation, productivity, and consumer demand. However, if let out of control, inflation will undermine the purchasing power of the dollar, push down consumer demand and increase the cost of domestic goods and services.

Strong dollar

Small cap companies are traditionally focused on the local US market. However, a strong dollar can make imports more price competitive against local products. The strong dollar also affects negatively business relying on exports. It makes US exports more expensive in local currencies.

Immigration

It’s a known fact that US firms tap into a foreign talent to fill out jobs that are not in high supply by domestic job seekers. Usually, the biggest portion of visa workers goes to larger companies. However, stricter immigration laws can still hurt the ability of small firms to hire foreign talent and compete against their larger rivals. Many tech start-ups, financial and biotech companies rely on foreign visa workers to fill out certain roles whenever they cannot find qualified US candidates. Agriculture and tourism businesses also depend on foreign workers to fill in seasonal positions. Tighter immigration rules will force these companies to increase salaries to remain competitive. Higher salaries will drive higher cost and lower profit margins.

 

Conclusion

While we are in a standby mode, the market continues to be nervous in anticipation of the direction of the new policies. For those interested in small-cap stocks, I would suggest looking for companies with an innovative business model, solid R&D and high-quality metrics like ROA and ROE. Those companies are likely to be more resilient in the long run, and less depended on policy changes.

 

Final words

If you have any questions about your existing investment portfolio, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

Investing in Small Cap Stocks

Small Cap Stocks

Small cap stocks are an important part of a diversified investment portfolio. They had provided high historical return and diversification, which are key factors in the portfolio management process.

Many flagship companies started as small businesses in a local market and evolved to large multinational corporations. Some of these success stories include McDonalds, which opened its first restaurant in Des Plaines, Illinois to become one of the biggest food chains in the world.

Research has shown that small-cap stocks overperformed a large cap over an extended period.

The below chart shows 15-year performance between IWM, Russell 2000 Small Cap ETF and SPY, S&P 500 Large Cap ETF. For that period IWM surged by 164% while SPY rose by 67%.

 

Once we include dividends, the 15-year annualized return of a small cap blend strategy becomes 8.66% versus 6.71% for a large cap strategy.

If we extend our period to 40 years (1975 – 2015), the small cap generated 14.25% annualized return while large cap produced 11.66%.

Investing in small companies comes with many caveats.  Even though they bring potentially high returns, they also impose high risk and uncertainty.

Small cap stocks market capitalization

Small cap companies have a market capitalization between $300 million and $2 billion dollars. Overall, the small size market is very fragmented. There are thousands of publicly traded small-size companies, but they only make 10-15% of the total market. The definition of a small-cap company varies widely among index providers and portfolio managers. Standard & Poor’s tracks their own S&P 600 Small Cap Index while FTSE Russell tracks the Russell 2000 Small Cap Index.

Very often, small companies are managed by their original founders.  They are usually new and innovative companies with competitive strengths in a particular local market or a specific product. It is not uncommon for companies to go back and forth between small, mid and large-cap rankings depending on their business cycle.

Niche market

Small cap companies often operate in a niche market where they have a distinct competitive advantage. Small businesses have a unique product or service, which they offer on either national or local level.  Unlike their bigger counterparts, which offer a variety of products in different geographies, small size companies tend to be more focused, with one or two flagship products. A particular example can be Coca Cola versus Red Bull. Coca-Cola offers hundreds of varieties of beverages worldwide while Red Bull offers only one type of energy drink.

Regularly small companies will start from a local market and grow nationwide.  Starbucks is a great example of a local coffee shop that moved up the ranks and became one of the top 100 large company in the USA and the world.

Small businesses with a unique product will often become an acquisition target for a larger corporation that wants to gain a presence in a growing higher margin market. Great example for that is PepsiCo acquiring Gatorade. PepsiCo wanted to get access to the fast growing market of sports drinks and instead of developing their own line; they decided to purchase an already established brand.

Growth potential

Small cap companies often have higher revenue growth than large size ones. Their competitive advantages, innovative strategy, flexibility and market positioning allows them to grow faster. It is easier to increase 25% when you start at $10 million of revenue versus $25% at $ 1 billion of revenue. Many times small companies do not even have a competition in their market niche. Think of Facebook before they went public. It is common for small firms to grow their revenue between 25% and 50% annually for several consecutive years.

Volatile prices

Investing in small cap stocks is risky. The high potential return of small caps comes with greater risk. The share price of small companies is more volatile and subject to larger swings than those of bigger companies.

IWM, the biggest small-cap ETF, has a beta of 1.22 to the equity market. As the comparison, the beta of SPY, the most traded large-cap ETF, is equal to 1. Beta measures the volatility of a security compared to the market as a whole. IWM beta of 1.22 shows that the ETF is historically 22% more volatile than the overall market.

Another measure of volatility is a standard deviation. It illustrates how spread out are the historical returns compared to the average annualized return of the investments. In our case, the 15-year standard deviation of IWM is 19.73% versus 14.14% for SPY.

As I mentioned earlier, the average 15-year return for a small cap stock is 8.66%. With a standard deviation equal to 19.73%, an average annual return can go between -11.07% and 28.39%. For SPY the average range is between -7.43% and +20.85% with annualized return of 5.25%. Based on this historical data we can claim that the small cap market has a much wider probability of returns. The high upside comes with a bigger downside.

Limited access

Small cap stocks lack the liquidity and trading volume of the large public corporations. This makes them more vulnerable to large price swings in short periods.

In times of economic recession, small companies can take a bigger hit in their earnings and may take a longer time to recover. Ten or fifteen percent decline in revenues can have a much more adverse impact on a small company than a larger one.

Due to their limited access to equity markets and loan financing, small size companies have a higher risk to go into bankruptcy if they run out of money.

Many small firms are start-ups with one innovative product and untested business models. Their dependency on just one product or service puts them in a very high-risk category in cases when the product or service does not appeal to their target customer base.

Inefficient market

Traders and portfolio managers often ignore small-cap companies. The focus is usually on large size companies, which frequently have 5 to 10 analysts following their earnings.  In fact, research analysts cover very few of the 2,000 stocks in the Russell 2000 index. Therefore, it is common that a small company does not have a full coverage by any industry analysts. This lack of interest and publicity produces conditions for inefficient pricing.   Active investors with a focus on the small cap market can scan the universe for undervalued and mispriced stocks and generate higher returns based on their valuation techniques and knowledge of the market.

Diversification

Investing in small cap companies can significantly contribute to the diversification of your portfolio.  Even though small stocks have a higher risk than larger ones, their correlation to the overall market is lower. A small blend strategy has 0.86 correlation to the overall US stock market and 0.56 to the broader international stock market.

A correlation equal to 1 shows the highest strength of the relationship between two asset categories. In the case of small cap, the correlation of 0.86 shows a weaker link with the overall market. Small cap prices does not fluctuate in the same magnitude and pace as the large cap companies.  While there is some influence by S&P 500, they follow an independent path.

 

How to invest in small cap stocks

Individual stocks

You can invest in small size companies by buying them directly on the open market. There are over 2,000 listed small size companies in various industries and stages of their business cycle. Naturally, you cannot invest in all 2,000 stocks. You have to find a way to narrow down your criteria and select stocks based on certain factors. Very few small companies have analyst coverage. Therefore investing in small caps stocks will require doing your own research, analysis, and valuation.

When you invest in any company directly, being that a small or large size, you have to keep in mind that concentrated positions can adversely affect your portfolio performance if that company has a bad year or goes bankrupt. While everyone’s risk sensitivity is different, I would recommend limiting the range of each individual stock investment to 1% – 2% of your portfolio.

Tax Impact

For the best tax impact, I recommend putting small cap stocks either in taxable or Roth IRA accounts. Small cap companies have higher expected return combined with a higher expected volatility. If you hold your stocks in a taxable account, you can take advantage of tax loss harvesting opportunities if a particular stock in your portfolio is trading at lower levels than original purchase price. Tax loss harvesting is not available in Roth IRA, Traditional IRA, and 401k accounts. I

If you have small-cap stocks with solid long-term return prospects, keeping them in a taxable account will also allow you to pay the favorable long-term capital gain tax when you decide to sell them.

Having stocks in a Roth IRA account will have even better tax treatment – zero tax at the time of sale.

Passive indexing

ETFs and index mutual funds are the top choice for passive small cap investing. They provide a low-cost alternative for investors seeking a broader exposure to the small cap market. Small cap ETFs come in different shapes and forms. The table below shows a list of the most traded small cap ETFs with AUM above $500 million:

List of Small Cap ETFs

TICKER

FUND NAMEEXPENSE RATIOAUMSPREAD %1 YEAR5 YEAR10 YEARSEGMENT

AS OF

IWMiShares Russell 2000 ETF0.20%$27.79B0.01%5.69%12.28%6.01%Equity: U.S. – Small Cap10/26/2016
IJRiShares Core S&P Small Cap ETF0.07%$20.83B0.03%7.35%14.16%7.56%Equity: U.S. – Small Cap10/26/2016
VBVanguard Small-Cap Index Fund0.08%$13.94B0.03%5.59%13.14%7.40%Equity: U.S. – Small Cap10/26/2016
VBRVanguard Small Cap Value Index Fund0.08%$8.16B0.04%7.31%14.20%6.77%Equity: U.S. – Small Cap Value10/26/2016
IWNiShares Russell 2000 Value ETF0.25%$6.72B0.01%9.39%12.17%4.82%Equity: U.S. – Small Cap Value10/26/2016
IWOiShares Russell 2000 Growth ETF0.25%$6.35B0.02%1.92%12.31%7.01%Equity: U.S. – Small Cap Growth10/26/2016
VBKVanguard Small-Cap Growth Index Fund0.08%$4.93B0.04%3.50%11.36%7.25%Equity: U.S. – Small Cap Growth10/26/2016
IJSiShares S&P Small-Cap 600 Value ETF0.25%$3.85B0.03%10.26%14.31%6.57%Equity: U.S. – Small Cap Value10/26/2016
SCHASchwab U.S. Small-Cap ETF0.06%$3.78B0.04%5.46%13.03%Equity: U.S. – Small Cap10/26/2016
IJTiShares S&P Small-Cap 600 Growth ETF0.25%$3.47B0.08%4.41%13.74%8.42%Equity: U.S. – Small Cap Growth10/26/2016
DESWisdomTree SmallCap Dividend Fund0.38%$1.59B0.12%11.96%14.36%6.35%Equity: U.S. – Small Cap10/26/2016
FNDASchwab Fundamental US Small Co. Index ETF0.32%$1.04B0.06%6.38%Equity: U.S. – Small Cap10/26/2016
SLYGSPDR S&P 600 Small Cap Growth ETF0.15%$807.64M0.27%4.61%13.74%9.00%Equity: U.S. – Small Cap Growth10/26/2016
VTWOVanguard Russell 2000 Index Fund0.15%$675.74M0.06%5.67%12.19%Equity: U.S. – Small Cap10/26/2016
XSLVPowerShares S&P SmallCap Low Volatility Portfolio0.25%$651.46M0.09%12.43%Equity: U.S. – Small Cap10/26/2016
SLYVSPDR S&P 600 Small Cap Value ETF0.15%$610.42M0.21%10.46%14.43%7.38%Equity: U.S. – Small Cap Value10/26/2016
SLYSPDR S&P 600 Small Cap ETF0.15%$512.80M0.25%7.10%13.99%8.19%Equity: U.S. – Small Cap10/26/2016

Benchmark

One of the main differences between small-cap ETFs is the index they track. Each of the three main Small Cap Indexes is constructed differently.

Russell 2000 (IWM) includes the bottom 2,000 of the largest 3,000 publicly traded companies. The average market cap of the constituents of Russell 2000 is equal to $1.9 billion. The median is 698 million. And the largest stock has a market cap of $6 billion.

S&P 600 Index (IJR) tracks a smaller subset of the market. It includes only 600 companies.  As of April 2016, the market capitalization of companies included in the Index ranged from US$ 400 million to US$ 1.8 billion. S&P 600 also sets additional requirements for liquidity, public float, sector and financial viability.

CRSP SmallCap index (VB) tracks the 2%-15% percentile of the total market. It has 1,462 companies. The smallest company has a market capitalization of $21 million; the largest has $7.9 billion. The average size is $1.85 billion. The median is $1.44 billion. It is worth noting that VB tracked Russell 2000 Index through May 16, 2003; MSCI US Small Cap 1750 Index through January 30, 2013; CRSP US Small Cap Index thereafter

Focus

Another big difference between Small Cap ETFs is their segment focus. There are three main segments – small cap blend, growth, and value. The blend strategy invests in the wide universe of small caps, which mechanically tracks the designated index. The value strategy tracks a specific group of companies that have a  certain level of Price to Earnings, Price to Sales, Price to Book, dividend yield, and other fundamental ratios. Growth strategy invests in a group of stocks that meet certain criteria for price, revenue and earnings growth.

Tax Impact

ETFs and index funds have more favorable tax treatment than actively traded mutual funds. Due to their passive nature and legal structure, these funds rarely release capital gains and losses to their shareholders. Therefore, investors looking to optimize taxes in their investment portfolio should consider these type of funds.

Active investing

This strategy includes investing in actively managed mutual funds. These funds are run by management teams. They normally charge higher fees than comparable ETF to cover for the trading, administrative, marketing and research expenses.  Mutual funds follow a benchmark, which is usually one of the three main indices described earlier – S&P 600, Russell 2000 or CSRP Small Cap Index. Because of their higher fees than comparable ETFs, fund managers are often expected to outperform their benchmark.

Active funds normally focus in one of the three main segments – blend, growth or value. The fund managers utilize a formal selection process that identifies a number of companies, which meet certain proprietary criteria. The end goal is to select those companies that will achieve a higher return than the undying benchmark. Since the characteristics of value vs. growth strategy can be subjective, it is not an unusual that the same company is owned by both value and growth oriented funds.

In the past 7-8 years, many of the active managers have been criticized for underperforming the market. Part of the reason is that we experienced a very long market rally driven by a small number of flagship companies.

Tax Impact

Actively managed mutual funds have a more complex tax structure. They must transfer most of their dividends and capital gains and losses to their shareholders. Mutual funds will often have large amounts of long or short-term gains and losses released in December regardless how long you had kept in your portfolio, to avoid paying additional taxes I recommend placing your actively managed mutual funds in tax deferred and tax exempt accounts. Another alternative is to look for tax-managed funds. They tend to have a low turnover ratio and tend to report long-term gain and losses less frequently.