Welcome to the third of a promised series to force some perspective and sharing here these few late summer / early fall weeks. Last week was the heaviest hitting material with a long look at when and how to stay the course. In particular, we took a square look at investing in the Great Depression. There really is no way to summarize that piece – I will shed modesty in suggesting you simply give it 20 minutes of your time. At least if you fear your investments going through a repeat of that nasty era. Here I turn to areas within the market to focus on but stick with the quote from the great Mariana Rivera again with “simpler is better” (Though this time I’ll lace with brevity as well).
We’ll always favor real diversification first and foremost but will also tilt towards areas representing the most favorable risk/reward asymmetry. The three areas that are worth sharing on this are high grade CLOs, value stocks and small caps. The value and small cap slant is the easiest to cover so I’ll start with those.
Small caps usually trade at a premium to large caps. This means that for every dollar of earnings, a higher price will be paid for small caps than their large peers. That’s because in the aggregate, small companies are poised to grow at a faster clip than large companies who are, again – in the aggregate, more established and matured. However, at this time small caps trade at a very large discount to large ones, seen easily on this chart from Yardeni Research.
At a multiple of 17.1X, the S&P 500 (Large caps) is near its long-term average. Meanwhile, the S&P 600 (Small caps), at 11.9X, is closer to its bear market lows of 2008 or 2020 than anything resembling a “norm”. This doesn’t mean small caps will be immune from any further pain. In fact, if we are indeed headed to a recession, that could spell for outsized trouble small caps. However, it does suggest they have asymmetrical potential relative to their big brother large caps or perhaps the potential to recover their prior highs earlier. Another of my all-time favorite charts was from the early 2000s where simply giving less weight to the big dogs of the S&P 500 paid huge dividends as those big dogs underperformed. Keep in mind both lines on the chart below are comprised of the same 500 stocks. It’s just that all stocks in the orange line are given an equal weight vs. the regular S&P 500 which gives a lot more weighting to the big dogs of the index.
These cycles of favoring large or small often play out over a very long term, so there is no rush to jump out and overweight them. But, when signs of market healing occur, small companies should be aggressively considered.
The rationale for value is similar, but perhaps a little timelier. Growth stocks relentlessly dominated value stocks following the 2008-2009 recession. So much so that the valuation spread between the two reached levels only seen in the dot com boom era (another era of frothy growth stocks).
You can see that play out below with the chart depicting the ratio of the level of S&P growth stocks to value (an increasing ratio would indicate value stocks outperforming growth, and vice versa). This ratio remains well below its longer-term average of 0.69. However, I say this is a timelier focus given that value stocks have begun the process of mean reverting by steadily outperforming since 2020. It hasn’t been a straight line, and there is no guarantee that the old norms will once again apply. But it represents another asymmetrical opportunity for a trend that would contain years of outperformance if it were to fully mean revert (or perhaps even overshoot to the upside).
The last area of suggested focus is more esoteric. Of the three, it would also be the one most likely to have a short shelf life due to its being pegged to the interest rate cycle. Rather than passively buying bonds or bond funds and holding them to maturity, tactically adjusting them can be rewarding if done consistently enough in conjunction with the cycle. That’s due to the nature with which the Fed announces their intentions, has to follow through on them and then consistently overdoes it. This creates a cycle where short-term rates go up too high, stay there for too long and eventually force the Fed to cut short-term rates to reverse that pain. At that point the Fed inevitably overdoes it by keeping them too low for too long and perpetuates the cycle. We’re very clearly in the part where they are reversing the implications from having been too low for too long.
If they follow through with their clearly laid intentions, short term rates should continue to rise….and stay there for a while. When the situation turns (and we have all of history suggest that it will), asset classes with fortunes tied to higher short-term rates become less attractive. But for the time being having highly graded tranches of Collateralized Loan Obligations represented in your portfolio is worth your consideration. For decades, these securities were the exclusive domain of large institutions. But ETFs have had brought democratized them for the masses like they have with many other asset classes. No shortage of scare tactics have been out there for the past several years about an imminent collapse in these CLOs like their CDO cousins from 2008. While I absolutely believe some pain could be in store for the underlying senior or leveraged loans that comprise CLOs, I think an opportunity has been kept open (high yields relative to their credit rating) because these two products simply sound alike. Lastly, I wouldn’t argue that all AAA or BBB tranches of CLO issues are the same, but the right ones done by the right CLO managers carry risk that isn’t quite to the degree that the parade of carnival barking internet authors would have you believe. Additionally, they are presently trading at a sharp discount to their par value, which could add to return when things heal.
I have intentionally avoided listing individual funds. This gives my Chief Compliance Officer a little breathing room. However, funds for all three of these areas can easily be located with some google searches to commence your own homework. Or, if you are an FEG client – you can rest assured these are areas that have our attention and why.