Today we’ll examine the growing tug-of-war that will determine the market’s next (likely dramatic) move and revisit my pick for the best paper ever written on investing.
FILE PHOTO: A trader watches his chart while working on the floor of the New York Stock Exchange July 8, 2014. REUTERS/Brendan McDermid/File PhotoBrendan McDermid/Reuters
Trends
Something’s gonna break
U.S. small cap stocks have outperformed The Russell 1000 large cap index by 10.1 percentage points month to date and outperformed the tech-heavy Nasdaq 100 by 13.8 percentage points. If the month ended Friday, this would mark the second and third biggest small cap outperformance in market history, according to Jefferies strategist Steven DeSanctis.
Sharp moves like this happen as a blow-off of pressure. In this case, the dominance of the Magnificent Seven, followed by the AI-related megacaps, left economically sensitive small caps massively neglected at a time when the avoidance of recession became the consensus view. Once the small caps began showing signs of life in early July, US$9-billion raced into small-cap ETFs.
Now there’s a new kind of pressure: anxiety. Most active fund managers and all S&P 500-based passive investors now have very large allocations in Magnificent Seven stocks that are beginning to wobble. The temptation will be to take profits.
Mr. DeSanctis believes small caps will continue to outperform thanks to Federal Reserve rate cuts and, more importantly, a small-cap earnings growth rate that will exceed large caps by the end of 2024.
The current average trailing price to earnings (PE) ratio of the Magnificent Seven is 49.1 times. For the Russell 2000 small cap index, it’s 30.1. The main reason the Magnificent Seven became so expensively valued is that there were few other options for strong earnings growth, so investors were willing to pay a higher price for the megacap tech stocks. That would change as profit growth for smaller companies improves.
There are strategists like Morgan Stanley’s Michael Wilson that disagree with Mr. DeSanctis’s forecast for small-cap relative performance. Mr. Wilson notes that earnings revisions breadth – the number of companies with rising profit forecasts versus those with falling expectations – is declining. Furthermore, this weakness is driven by economically sensitive sectors like autos, materials, and consumer services and this does not bode well for small-cap performance which is broadly dependent on strong U.S. growth.
There is one plausible and painful scenario where earnings improvement for small caps leads to a convergence of Magnificent Seven and small cap PE ratios. The former’s PE has a long way to fall from 49 times and because they account for over 30 per cent of the market cap weighted S&P 500, index returns would be abysmal during the process.
Conversely, a slowing U.S. economy (as indicated by the ISM manufacturing PMI data, which remain in contractionary territory) might lead to the Russell 2000 returning to the 1600 to 2000 range where it sat for the 18 months up to December 2023. The small-cap index, however, is up 38.5 per cent from the October low and settling back would also cause investor pain. In this hypothetical future, investor assets likely head back into large-cap technology and make expensive stocks even more expensive.
I sense a strong sense of pressure and tension in current markets as investors are pulled in different, even opposite directions. If I’m right, when the market breaks and picks a direction, the move will be fast and dramatic.
Getting smarter
The best investor paper ever written turns 20
May of this year marked the 20th anniversary of what I believe is still the best single paper ever written for investors. Columbia University finance professor Michael Mauboussin, then acting as the chief investment strategist at Legg Mason Funds Management Inc. (his full resume is ridiculous), published Decision-Making for Investors: Theory, Practice and Pitfalls on May 24, 2004.
Here are just a few observations that make the paper great:
· The most successful people in different probabilistic fields have more in common with each other than the average person in their field.
· Successful investors focus on process first, then outcome. He uses famous gamblers to make this point.
· The best investors search for the rare opportunities where they are certain they have an advantage.
· “Considering every financial situation in probability and outcome terms forms the core of a sound investment process.”
· A skilled investor can be wrong more often than right as long as the size of the wins offsets total losses.
Mr. Mauboussin wrote something elsewhere that I think about all the time – in games of skill, unlike games of luck, you can lose on purpose.
Stockpicking may be considered a skill. But losing a stock picking contest is not that easy, so a significant amount of luck is also involved.
Diversions
Summer reading done right
George Mason University economics professor Tyler Cowen published a column last month arguing a sentiment I agree with – that The Best Business Books Aren’t About Business. First, Mr. Cowen recommends books be on the topic of the industry a reader works in - which will help make it more meaningful. Failing that, the professor argues that the best books about management – those most enlightening about interpersonal relationships, motivating talented people and dealing with failure - are biographies about sports teams and music groups.
I would add historical fiction as a good explication of the stubborn intransigence of human psychology if well done. A Conspiracy of Paper by David Liss and The Thousand Autumns of Jacob de Zoet by David Mitchell are good examples with a business focus. Incognito by neurobiologist David Eagleman was mindboggling and informative.
The Essentials
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Globe Investor highlights
Two megacap stocks were largely responsible for the benchmark S&P 500 Index suffering its worst day in 19 months last Wednesday. Like Wile E. Coyote, the soaring U.S. stock market may be starting to feel the tug of gravity. Ian McGugan has some advice on what investors should do now.
David Berman asks: If more rate cuts are coming and tech stocks lose some of their lustre, are utility stocks the sector to own? And speaking of rate cuts, Rob Carrick suggests its time to get an exit plan together for your cash holdings.
Norman Rothery tells us about a portfolio that has achieved average annual gains of 20 per cent over 25 years – and some wild swings to show for it. And if that type of volatility makes you nervous, Gordon Pape suggests an ETF that might be more appealing.
What should an investor in A&W Revenue Royalties Income Fund do following the proposed combination that will turn it into a new publicly traded restaurant business? John Heinzl has some advice.
There’s no doubt private assets can be an excellent return generator and diversifier, but there are trade-offs that all the enthusiasm usually obscures. Tom Bradley provides some things to consider before wading into the private asset market.
What’s up next
Looking ahead: BofA Securities investment strategist Michael Hartnett wrote that U.S. markets are “one bad payroll away from cracking the oligopolistic dominance” of the AI-centric technology megacaps, so I’m already looking forward to the non-farm payroll report on August 2.
More immediately, the Nasdaq 100 is trading close to its 100-day moving average after blasting through the 50 day without hesitation. We’ll see if the 100 day holds or at least provides some resistance to the sell-off.
The relative performance of the Russell 2000 and the S&P 500 remains a key indicator of market breadth.