Fundamentals in investing relies on business plans, quality of management, earnings estimates, and revisions and all the research and data that measure a company’s performance against its goals. It’s the Ben Graham style of investing. Buy quality companies with a good business model/management and hold it forever.
If you’re a fundamental guy like I am, these times are the ones that have you totally confused. Earnings are uncertain at best, multiples (P/Es) are extremely high, which leads the Ben Grahams of the world to tell you “this market is expensive”. Presently (according to Factset), Price to Earnings Ratios currently have us at over 24 times next years earnings. The longer-term average dating back 25 years is between 16-18 times.
Thankfully today we have a lot more history (and recessions) than when the late, great Ben Graham was around. Recessions are like meat grinders and valuations normalize over time.
The above graph, (which I’ve shown you previously) is a great visual of how over the two years following the start of a recession, valuations tighten into a predictable spread. They don’t always start as expensive, after the financial crisis in 09, multiples became extremely cheap.
This period (from a P/E perspective) looks like the 2001 period. Both periods started with high valuations, featured an exogenous event, and started with a swift recovery from a crash. How do P/Es normalize? One of both sides of the equation need to move: Price or Earnings. So, from where we are now, either the Earnings will need to come up to justify the current price, OR the price of the market comes down.
Don’t panic – Enter the Fed. We have seen the Bazooka, which helped stop the bleeding. From here I fully expect to see longer term fiscal response, which historically takes longer, is messy, and creates volatility based on how effective the response. The 01/02 fiscal response did not satisfy the market and created a decline in markets in 2002. The 2009 fiscal response was celebrated and was followed by a market rally. This time around we are in an election year. How can that not be a positive for a solid fiscal response? Last week I outlined a timetable for another round of stimulus as well as a infrastructure spend.
Note stage 4 in the graphs…”Sifting through the Ashes”. I would argue that we are still a little ways from being in phase 4. This will be a time period after the fiscal response is complete (probably Sept/Oct timeframe).
It’s never too early though to try to find sectors of the market that have been unloved, and that for me is small caps. Small Capitalization companies are those that typically have a total net worth of less than $2 Billion, measured by the Russell 2000 index.
Small caps are currently trading at a 20 year low in valuation compared to the S&P 500. Typical Bull Markets have been led by small caps, due to their ability to increase market share versus their larger cap counterparts. Reinvesting in their business to fund growth, and quickly adapt to market opportunities.
The negatives for small caps are usually related to their debt levels. When the economy slows, the loans still need to be paid despite revenue declining.
Large Caps have been totally dominant since 2018. The big have gotten much bigger. A recent article on CNBC.com had the top 5 companies in the S&P 500 making up 17.5% of the index. Leaving the other 495 companies fighting for the other 82.5%.
Fast forward to today. A vaccine is on the horizon (which can hopefully return us to economic growth), unprecedented fed stimulus, and a zero percent fed funds rate and credit spreads tightening have the ability to give the small caps the boost they have been looking for.
Shorter term, I acknowledge the spikes we are seeing in Covid cases, and a possibility of restrictions in “hot spots”. The main stat that I’m watching here is the U.S. Daily Hospitalizations, which have had a slight uptick. Our RJ analyst following the virus, states that most states have plenty of capacity in hospitals at the present time. Let’s follow this chart. I’ll send it out each week while we have cases rising.
With that said, here is the buy/sell
Mick Graham, CPM®, AIF®
Branch Manager Raymond James
Financial Advisor Melbourne, FL