1. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Yahoo! Finance.
Thought for the Week (276):
A Subtle but Crucial Data Point
Synopsis
A key component to our secular bull thesis on equities is the overall strength and direction of the U.S. economy.
As third quarter earnings wrap up, small cap stocks have significantly outperformed large cap stocks on the back of solid earning – an important leading indicator for our economy.
Given the setup for a slow and steady rise in equities, we strongly urge investors to continue to focus on the long-term fundamental drivers of stocks rather than media-driven, short-term noise.
Valuations Here Have Risen for Good Reason
We believe that we are in the early innings of a secular bull market for equities in the U.S., and new data has emerged through the third quarter earnings season that further support our thesis.
Before we dig into this data, let’s first explain why we have been so bullish on the U.S. equity market since the end of the financial crisis of 2008, or what many refer to as the “Great Recession.”
The chart below shows the economic cycle from boom to bust, and generally speaking most developed economies follow this pattern where short-term cyclicality causes recessions and recoveries, while the long-term growth trend (the black line) typically rises over time.
Currently we believe that the U.S. economy is in the early stages of a recovery (the green arrow) for the following key reasons:
Recovered the Fastest: We recovered the fastest from the Great Recession, and now we are well ahead of the rest of other developed economies in Europe, South America, and Asia. Our pace of recovery should continue to attract investment from every corner of the globe.
2. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Yahoo! Finance.
Learned Our Lesson: Companies that survived the “Great Recession” learned their lesson and now operate at the most efficient levels in history. Operating margins are at record highs, workforces have been right-sized, and excess spending has been significantly reduced.
Manufacturing Coming Home: We are witnessing the reversal of the outsourcing trends of the 1990s where companies were sending jobs to lower cost regions of the world. Now that this wage gap has narrowed, companies are now bringing jobs back to the U.S.
Consumer Confidence: Consumer spending accounts for 70% of our gross domestic product (GDP), a measure of economic growth, and confidence is trending higher. Furthermore, replacement cycles for good such as autos were extended too far and must now be replaced.
Energy Independence is a Reality: Technological advances in oil and natural gas extraction have unlocked vast reserves of energy below our feet. Cheaper domestic energy gives companies located here a cost advantage, consumers pay less at the pump, and we could eventually become a net exporter of energy to other nations.
The bottom line is that valuations in the U.S. relative to the rest of the world appear expensive, but much like in real estate, expensive neighborhoods are priced higher than others for good reason – because they’re worth it.
NOTE: Investors may be able to realize higher returns in other economies as they trail our recovery if one were willing to accept more risk. For example, Europe is now emerging from their recession and while we remain positive on their recovery, we still feel that the “risk-adjusted” returns are less attractive than here.
Smaller Company Earnings are Critical
The smallest stocks are rallying almost twice as fast as the large ones through third quarter earnings. Shares of small caps have advanced 32% in 2013 compared with 19% in the Dow Jones Industrial Average, and the spread between the two is the widest for any year in a decade.
A major driver of this outperformance is attributed to smaller company’s earnings exceeding estimates by a wider margin than larger companies. The companies in the Russell 2000 index are beating analyst estimates by 11%, more than twice the rate for companies in the Dow, and analysts now predict that smaller companies will boost profits at more than four times the pace of larger firms next year.
This phenomenon is so important because, based on data compiled by Bloomberg, three out of the last four times that small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more.
Now fundamental investors should always keep in mind that the past does not always predict the future, so we must first understand why these leading indicators work more times than not. Only then can we further support or possibly even refute an investment thesis.
The reason why small cap outperformance is such a strong leading indicator is due to their dependence on an improving U.S. economy. Companies in the Russell 2000 generate 84% of their sales from the U.S. on average, compared with 55% for the Dow (larger companies are typically more geographically diverse). When small caps are outperforming large caps, we are often able to conclude that our economy is in fact strengthening.
Therefore, smaller companies usually climb faster at the start of a bull market, making them a proxy for future economic activity, and this key insight is another major supporter of our overall thesis on the U.S. economy.
3. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Yahoo! Finance.
Implications for Investors
Small cap outperformance may appear to be a subtle data point compared to the overarching fear from talks of tapering the Fed’s Quantitative Easing program or perhaps even another government shutdown come February, but we strongly urge investors to focus on what matters to the long-term earnings of companies.
The overwhelming majority of the time, the short-term disruptions alter very little in a longer-term thesis for owning securities, and investors can profit by using them as wonderful buying opportunities to add to positions in stocks when they go on sale.
Therefore, we welcome the media’s focus on these short-term disruptions because this adds fuel to the fire of fear and panic from market timers and traders, and we will continue to be patient and methodical while we look for opportunities in stocks that go on sale.