Given the popularity of our weekly Market in Pictures, we thought it made sense to pick out a few and go into more detail with our PMs. In this edition, John Luke and Dave spend a few minutes on each of the following:
- Small caps wake up in July
- FOMC could/should hike but waits
- Earnings Season midpoint
Hope you enjoy, and please send a note to [email protected] if there’s a particular chart/topic you’d like to see covered next month. Time to swing it around!
3 Minute Read: Executive Summary
Full Transcript
Derek
Welcome, welcome August 1st. Lots going on in the markets, a lot going on. It’s been quite a bit of activity. July was a little different than some of the previous months coming in. So we’ve got David Wagner, CFA, who heads our equity team, and John Luke Tyner, CFA, who heads our fixed income team and we’re going to talk about what’s been going on. I’ll read a quick disclaimer and then we will roll right into it.
The opinions expressed during this call are those of the Aptus Capital Advisors investment committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus’ investment advisory services can be found in its form EDV part two, which is available upon request.
So what you got guys? Lots going on out there. I don’t even know where to start. We got a few charts in here for our typical top three, but I don’t know. You may want to have some thoughts before we even get into those.
Dave
There has been time to really think over the past few weeks given the amount of information that’s been coming out. I mean just look at the PMI data this morning that really sunk small caps. I mean we’re starting to recognize that whether it’s manufacturing or services MI, it’s not just a bad data print anymore. It’s becoming a trend and the market’s starting to recognize that and something that we’ve been saying, whether it’s on our outlook heading into this year or really any of our calls, it’s all about growth right now. And obviously when you get data points like that throwing some type of negative trend, the market’s definitely going to take note. And it took note today here on August 1st with small caps down three point a half percent.
John Luke
Yep. Yeah. And on the rate side, a lot of questions of whether we’re seeing an initial policy mistake with not cutting in the face of a number of data points weakening, inflation moving back down below the longer term average, although it’s above target, it’s still two point something which we thought would be good enough to declare victory. Seeing unemployment tick up a little bit and just policy work’s on a lag and you’re seeing a lot of that kind of flowing through. And I think top of mind for the Fed was at the end of last year, they got a little giddy. Remember at the beginning of the year, rate cuts galore were priced in for the year, then inflation turned back up and I think that might be ultimately what kept them from initiating the cut yesterday.
Dave
John Luke, we don’t really make a whole lot of calls with at least on Fed decisions, but I would say that going two, three weeks ago, me and you had a conversation we’re like, you know what? The Fed or pardon the market should definitely be pricing in more of a rate cut in July than what it is right now. And I’m a firm believer actually that they probably should have started. Obviously Fed loves messaging consistency in and of messaging, so they definitely wanted a meeting to kind of set the stage for a rate cut. Maybe in a way it is partially rate cut because the market is pricing that in a little bit on the rate side. I mean just today JL what? We just had the 10-year good below 4% for the first time since when? A while.
John Luke
Yeah. I mean for the month the two year dropped almost 60 bps and the 10 year dropped almost 50 bps. So it’s been this type of month happens every couple of years where rates move this much to the downside and it’s definitely eyeopening.
Dave
I know we [inaudible 00:03:46] have a fixed income slide in here JL, but that’s such a great point because everyone’s been calling for rates to come down and even after this move, the substantial move that you just mentioned right there, people are still calling for rates to come down even more. And I think that’s just a topic that let’s definitely talk on today.
John Luke
Yeah, agree.
Derek
JL was all over Paul and the Fed at the beginning for not hiking and just pounded that higher for longer forever, forever. But you did turn on a dime about a month or so ago and said they need to start cutting. It’s finally time. And so I guess he’s going to lag behind you again just by a little bit at least.
John Luke
Yeah
Dave
JL critiquing the Fed. What, what?
John Luke
You’ve got real rates at close to 3%. If we were sitting here looking at inflation still at four or 5%, then that’s a whole nother story. That’s kind of where we were at the end of last year. But now you’re just at an environment where what’s 25 basis points going to do to re-spur inflation? Probably nothing. But what could it do to at least send some sentiment to the market that some of these interest rates, cyclical sectors, housing, autos, RVs, stuff that’s gotten absolutely destroyed, maybe you put a little bit of at least a floor underneath it and that’s what I think we need to see.
Dave
And John Luke, I think one thing I got wrong was a few months ago I was like, yeah, they’re going to start cutting rates, but who cares? It’s only 25 basis points after they what raised five and a half percent over a period of time? But I think you’re exactly right with your point there, some of these smaller cuts are actually very, very important from at least a transparency of what the Fed’s thinking because I think there’s a great separation between the size of the cut and how the market performs. So I do think it’s very important even at 25 bps.
John Luke
Yep.
Derek
All right. Well let’s pop in and go through a couple of these charts that y’all put together. All right. Yeah, you can’t ignore this one. I mean wild turn of events in two weeks. So Dave, talk us through it.
Dave
Correct my grammar here, my verbiage here Derek, but that needs to happen a lot more often and we all know that, but hopefully I use this for right. It’s a pyrrhic victory, correct? Small caps have continued to underperform large caps for basically three, four years. It’s kind of like that meme that you see out there on Instagram, Twitter or whatever you get your instant gratification news on. A guy’s on podium celebrating a third place finish spraying a bottle of champagne in his face, yet he is not in first or second place. And it just kind of felt like that for small caps here. I mean this move that we’ve seen in small caps versus large caps, specifically the NASDAQ, I mean this was basically a fixed standard deviation move. There’s a point at seven or eight trading days where this was the largest spread in performance discrepancy between small caps and the NASDAQ itself.
I think at what core of what really happened here was that I think there’s a lot of de-leveraging on long short hedge funds. In the most simplistic form macro, long, short funds their trade is if the market’s accelerating or if the economy is accelerating, they go long, small and short, large. And if the market’s decelerating, they go long, large and short, small.
And given the performance discrepancies of just the NASDAQ and large cap substantially outperforming small caps over the past three, four years, I think the position just kind of got out of hand. This rally that we’ve seen in small caps, small caps are now from a performance standpoint in line year to date versus the NASDAQ, it’s unbelievable. But given our recency biases and just only knowing what’s going on over the past, I think if you zoom out on the picture of small caps like we all know, we’ve been taught in school that small caps, there’s a higher equity risk premium there that you take on more risk for the potential for more return and that small caps tend to outperform larger caps, large caps over a longer period of time. That’s completely true,
But I think still even over the last 23, 24 years, and that’s what this chart is showing, it’s going back to March 31st of 2000 and ends this past month that small caps have actually been outperforming large caps, or pardon me, NASDAQ since 2000. In fact, I think, John Luke correct me if I’m wrong with this statistic, I think we saw 20 or 21 straight years from 2000 to 2020 of small caps outperforming large caps. It might even gone into 2021 and people forget that. That’s a heck of a streak of small caps outperforming. So I do love it and welcome this reversal being the small cap guy. I mean it’s very cool to see that small caps are a cool thing now again. I know people want to talk small caps.
The last thing I’d want to say here on small caps is something a little bit different than what I think a lot of people are saying out there. It’s definitely not consensus. Everyone wants to play small caps for the valuation mean reverser versus large caps. We know historically speaking that small has traded at a premium of 4% to large caps over a longer period of time. And now even after this recent rally, small caps are trading at a 30% discount.
And that’s why a lot of people want to own small caps, they want to have that mean reversion, but I actually truly believe that small caps have re-rated lower that, I expect some type of mean reversion, but I don’t expect it to go back to historical standards on a relative basis versus large. And when you hone stuff back into everything that Aptus does here through our yield plus growth framework, let’s walk through that. We have total returns driven from three sources, yield growth and valuation expansion and contraction. And if my theory is right and everyone knows I love small caps, I would name my firstborn male small caps if I could, I love them so much.
But if you look at those three factors, yield growth and valuation expansion or contraction, if this re-rating has occurred and given them out of low quality zombie companies and non-earning companies in the small cap lane, you really have to focus on the first two aspects of total return for small caps, yield and growth because I don’t think you’re going to get as much valuation expansion as you may want in this trade, but there’s tons of opportunity for growth within small caps if you delve underneath the hood and if only there’s some strategy active ETF in a small cap space that focused on above average yield and above average growth, it would just be like a perfect magical elixir [inaudible 00:10:28] concoction for owning small caps.
John Luke
That’s great. Yeah, the spread was like the NASDAQ was up 22% through July 10th with the Russell up 1% and then fast-forward to the end of month and it was in parity?
Dave
Yeah, I mean it was fast and furious. That’s why I think it was a little bit more de-leveraging than anything. I think where the market could get part of this trade wrong is that obviously it was based off the expectations of rates to come down, which benefit small caps, small caps that are, if you take all the debt in small caps, 70% of it is variable rate and they have a debt maturity wall that’s coming due very much sooner than large cap, their large cap brethren. And if we do get a downturn, I actually don’t think that they’re going to get as much of a benefit from the interest rates coming down as what someone would think because there’s going to be some type of probably credit spreads expanding, which may negate the benefit of savings on interest expense rates. But that just hones in on the necessity to be active in the small cap space and the necessity to own a small cap strategy yielded growth.
Derek
Well covered, well covered. I think definitely the key has been, I don’t know how many days, but day after day for the past couple months it’s been a green, red like these two have been flip-flopping. Leading up to that, NASDAQ just on fire when Russell couldn’t go up. So we haven’t really had a ton of days where they participated together in a similar direction and that doesn’t seem to be changing. All right. What we got? We got bonds. Obviously JL has had a lot to digest and seem to be at a critical moment. We’ve been in pause mode forever and I think everybody assumes we’re coming out of that, but what are you showing us here, JL?
John Luke
Yeah, so this is a combo chart. It’s showing S&P performance around Fed cutting cycles and what performance has looked like coming out of those cutting cycles. And really I think the alligator jaws, their difference is markets typically perform pretty well when the Fed is cutting into a softer landing type of environment. So not an abrupt slowdown in growth, not an abrupt slowdown in employment, things like that. And that’s the blue line where typically markets are finishing higher post rate cuts and the gray line is sort of the inverse of that when you do have a recession and the Fed is cutting in response to something. And obviously that’s the type of environment that we were talking about at the beginning, that we’re trying to avoid is just softening policy to make up for as inflation moves down and policy rates are held at a certain level, the level of restrictiveness continues to get tighter and tighter and tighter as inflation comes down in real terms after accounting for inflation.
And so that was my point where real rates right now are around 3%. If you look the past 24 years, that’s pretty high. At the early 2000s, you had real rates at a higher level and then we went through a period where real rates were low, they were actually negative for a lot of the post financial crisis period. But I think right now you’re just seeing the impacts of real rates that are creating slowing down of the economy and the Fed has to be very careful to make sure that we get this soft landing by lowering the level of restrictiveness, not to reignite the economy and bring back inflation, but just to tame a lot of the tightening that we’ve seen to kind of hone back in since, the whole 2020s decade has just been a big mess. You start with the pandemic, you create a bunch of stimulus, you put it into the economy, you get the after effects of inflation.
It’s really the main question here and can dovetail into the next point is like are we in an environment where the economy can grow at a healthier clip than we saw post the financial crisis? And the people that are in the camp of yes are the people that think that there’s going to be continued pressure on bond yields and the people that are in the camp that say no that we’re going back to that lower growth environment, that’s the bond bulls. And I think to get to that point, if you look the last 30 years, the term premium, which is, I’ve written a ton about it, but for everyone that hasn’t read it is basically the level that bond investors require as compensation for the inflation risk, the duration risk, the liquidity risk of lending longer term periods to the government. So the last 30 years, the term premium, so think about like a 10-year bond, has been about 75 basis points over the Fed fund rate.
If you look back the last 60 years, it’s been about 150 basis points and you’ll recall that the last 60 years is going to incorporate in the great inflation of the seventies, a lot of some political turmoil and things even before that. And so my main point is we’ve seen this massive move lower in bond yields, the 10 years below 4%. Again, we started July 1st at 4.46, so call it 4.5%. You’ve seen the bulk of this move and I was looking at another chart that was just talking about the move and interest rates typically happens before the Fed cuts and that’s already getting priced in, which I think is exactly what I’m trying to make here. So if you think about the yield of a long-term bond, it’s the Fed fund rate plus a term premium. The Fed’s telling you that the Fed fund rate the neutral rate is going to be 2.8%.
So if you say let’s just cut the difference and say hey, the term premium looking forward is going to be about a hundred to 125 basis points. If I take 2.8 plus that, you’re in a 3.75, 3.8% type of 10-year environment. And that’s basically where we are right now. And so with my final point being the CBO just has told us repeatedly that we’re going to run 6% deficits for the next 10 years. So in my mind it just does not make sense to buy bonds at less than 4% yields where there’s not a whole lot of potential for price return. A lot of it probably has already happened. So if you were going to be tactical, the time to get tactical was in April, not now.
And so I think just to kind of finish it off, we’ve seen a big move in bond yields, but it’s just hard to see how we get substantially more price return. And you put onto that, the last thing is the Fed has issued a ton of T-bills the last couple of years, specifically the last call it 10 months, where they’ve really focused on issuing a lot of the US government’s debt at the very front end of the curve. A lot of that is debatable of the purpose between why and it pumps liquidity into the system. It’s kind of stealth QE, but the ultimate thing is at some point that has to turn and they have to start issuing longer dated debt. And so whether it’s term premiums rising back up to account for that, there’s just likely going to be pressure on the long end of the curve. And I think that structurally that’s going to be a problem that a lot of asset allocators face with the next five or 10 years.
Dave
I have nothing to add there. That was just great. It just is another example of the bond guys being smarter than the equity guys guys.
John Luke
It’s a lot of info, but I think the scope is own more stocks and hedge away risk, don’t rely on bonds to help and maybe you get some correlation benefits from energy from the average stock from small caps that we haven’t been able to get for a while and they help make up for that.
Derek
So I guess I know the next chart that’s coming up. So tying this one in, it’s not a huge sample size, but it’s a pretty significant difference in performance whether we go into recession or not. And I guess a lot of that you can take macro signals and look at GDP or you can take micro signals as basically what’s going on with individual stocks. So this at least probably gives you kind a diffusion index type of way of looking at it to say, all right Dave, what’s going on with earnings? Or that’s going to be probably the first sign that the economy is either going into a recession or is going to have a soft landing.
Dave
Yeah, you’re right. It all just comes down to growth. I mean you could put us on a recorder and repeat this every single year, every single quarter itself. And obviously I was looking more top down with my PMI comments at the onset of this call, but there’s no better source to have an ear to the ground than coming from the horse’s mouth themselves, their CEOs and their guidance and their commentary. Apple just reported their earnings rate behind me, Amazon just did. So a lot of these numbers are going to change here shortly and so we’ll probably talk about this subject in another week or two.
But my two takeaways, and a lot of this is going to be more anecdotal right now when it comes to earnings, but anecdotally, two things that I’ve kind of been watching. First thing is that valuations have started to matter here, that when you see a company report earnings and it’s in line and their valuation may feel a little bit extended, they’re getting absolutely rocked. I mean just today, I mean think of how many stocks, Snap is down 22%. I could go through a Dexcom last week it was down like 33, 35%. I could go through a slew of stocks where it feels like these stocks have been extended, earnings were okay, they weren’t bad, not terrible and these stocks are getting absolutely obliterated.
But then you’ve got some other stocks out there that maybe their valuation is a little bit more palatable and they had okay earnings, maybe even [inaudible 00:20:30] bad earnings and the stocks popped the next day. The first company obviously talking Compounders, we have a huge presence in the Compounders 15 stock portfolio. Look at a Visa. Visa I thought had horrible earnings and that’s okay. Obviously we [inaudible 00:20:44] name for the long term. They can have a bad earnings report, that’s okay. But their valuation is so substantially cheap relative to themselves and versus the S&P 500. Visa is trading in the lowest percentile, lowest one percentile versus itself over the last five and 10 years.
If you compare it to the S&P 500 and exclude MAG seven, the magnificent seven stocks on a relative basis, it’s trading in the lowest decile over the last five to 10 years. And it was a horrible report. The stock was only down 3% or so, and I thought that was much better than what I anticipated going into the day. Same thing would happen with Chemed. VITAS is kicking butt finally and Roto-Rooter seeing some more cyclicality. That’s actually trading now in line with parity with the S&P 500. It’s just an okay report and the stock was up. So it’s showing you that valuations do matter right now and that should be a focal point for investors, especially as we go later on into the overall business cycle. I hate using the analogy of baseball, big baseball guy, I am, but everyone wants to know what inning are we in? I have no clue, but it does feel like we’re further down the road than we were just a few years ago so people have really started to focus on valuation more so.
So, that’s kind of the first anecdotal minute thought point that I’ve had regarding earnings. And the second is, and John Luke, I’m going to need your help on this one. Someone put out a report maybe a month or two ago talking about how long it actually may take for a lot of companies to see profitability or ROIC on CapEx spending in regards to AI. It was one of the big shops put this out there, a few stocks pulled back just that day because they’re the behemoth in the space, I’m blanking on it, but we saw that commentary with Google, we’ve seen that commentary elsewhere.
I still think that the picks and shovels methodology and the AI narrative probably have some room to run. I mean there’s going to be air pockets no matter what. And this was just an air pocket off a commentary, not on results or CapEx spending. So I really think that that’s just going to be a focal point for the markets because just simple commentary around AI and CapEx and the profitability aspect there has been weighing in on stocks in the market itself. I think it was maybe High Point or someone, John Luke, that came out with that report. It’s one of the big behemoth hedge funds and I think they are onto something because there are going to be winners and there’s going to be tons of losers.
But again, the best way to play this AI narrative is be very simplistic. You don’t have to be complicated here by trying to choose the winners and the losers. Attack this problem at the overall asset allocation level because if this narrative continues, if this narrative takes off to some type of productivity boom, if you own stocks, you’re going to benefit for that. And obviously our big mantra here at Aptus is more stocks, less bonds, risk neutral by simply having that type of structure at the allocation level, you’re going to benefit from AI here.
John Luke
Yeah, I think that goes to the first six months of the year we really dominated or the first six months and 15 days we dominated because of the asset allocation, our overweight to stocks in that right tail move really just was great. I mean it was about as good of a test case for our portfolios as could be seen, but really I was happy about the back half of July where you had this broadening out of markets and our exposures to other things than mega cap tech came into the fold and help models especially up the risk spectrum.
So I think that, like you said Dave, and we’ve all kind of made comments, you’re in an environment with big deficits on the fiscal side. You’re in environments where a lot of these big companies are just behemoths and what Google is making a billion dollars a quarter in interest income, how do you eat that? And so just the ability to tap into more stocks and less bonds I think is going to position folks much more appropriately for what’s to come which I would not be surprised if it’s a lot more of the same of what we’ve seen in the last year and a half.
Dave
You touched base on the right tail there with our allocation, John Luke, and you’re exactly right. What’s been driving our performance is at the asset allocation level is unbelievable on the right tail side, but even on these small pullbacks, I mean we saw a pullback back in, the April showers will pull back with 5.2% in the S&P 500. We just had a slight pullback there from January 15th, or pardon me, July 15th to July 25th. I think the S&P pulled back maybe 4.92%.
I’ve been very impressed even though that’s a very short period of time and a very small minor pullbacks how a lot of funds that utilize [inaudible 00:25:23] and asset class and or guardrails for the portfolio, how they performed their downside capture, that they were still able, given the volatility levels, how cheap insurance is right now, that even on small minor pullbacks, performance was there. It was great downside capture. It was amazing because as everyone heard me say, we on average see the market have three 5% pullbacks and one 10% pullback and we basically just witnessed two of the three 5% pullbacks in the market so far. And the guardrail ETFs that involves an asset class definitely performed well in the small, they were very quick pullbacks, but they performed well.
John Luke
Yeah, definitely.
Derek
All right. So I guess that’s a good wrap of some of the stuff that went on in July. When we come back next month we’ll have, there’s going to be a few more earnings reports trickle in, but a lot of them are out at this point. And I guess the Fed just kind of left a void here where earning season is going to be over. You got non-farm payrolls tomorrow and then you’ll have another one at early September. You got a CPI in there. You got Jackson Hole in there. It’s going to be kind of a little bit of a vacuum if some funky macro reports come out probably, right? Either way.
John Luke
Yeah, Dave and I talked about this earlier. It would look really terrible if the Fed came out between now and September and did a cut. I think that would really spook the market. That would be, I just expect that they’re going to deliver the cut in September and I would not be surprised if data doesn’t look great if people are parroting for 50 basis point cut to start things off. But we’ll see.
The market has been head faked so many times the last two years where the consumer’s been resilient and last summer think about you saw some upticks in unemployment claims and some worries about labor market and then it’s snapped back. So I guess the real question here is does things sort of snap back and the economy, is it handling rates in a better capacity than people expected? So if we continue to see that, I would not be surprised if the recession fears that you’re kind of seeing creep into markets the last couple weeks were quickly evaded.
Dave
JL, did we just go through a whole three pointers call without a trivia question?
John Luke
Or without politics?
Derek
We did.
Dave
Oh, you broke a no hitter.
Derek
I think I might hit the stop recording button.
John Luke
All right.
Dave
Please.
John Luke
Thanks guys.
Derek
No, nice work. Thanks for the recap and good luck out there.
John Luke
All right, bye guys.
Derek
Talk to y’all soon.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security.
The opinions expressed are those of the Aptus Capital Advisors Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed.
Aptus Capital Advisors, LLC is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call (251) 517-7198. ACA-2408-5.
