During some recent time in Colorado, I happened upon a rodeo. Beautiful Saturday afternoon. Azure blue skies. Cowboys and cowgirls on horseback. Mutton busting. Bronco riding. And a master of ceremonies snorting out the most politically incorrect brand of humor I'd ever heard.
What's not to love?
Of course, what self-respecting rodeo would be complete without a coterie of tobacco-chewing, steel-twisting, whiskey-sweating bull riders. Willing to risk life and limb trying to tame a testosterone-snorting, 1,600-lb. roan bull.
Which led me to ponder those investors arriving late to this six-year stock soiree. Those recently having to decided to climb on. Give the bull a ride.
Depending on one's vantage point, you might find any number of disparate opinions on where today's investment opportunities lie. None of which is certain. Most of which are incorrect.
Fact is, this market has become long in the tooth. Six years after the Credit Crisis's nadir, the market is beginning to resemble your 71-year old Uncle Buck. Jet black hair. Skinny jeans. And a youth medium designer tee shirt. Nice guy. But his appearance is unnerving. Point being, this market has begun to look out of place. And like Uncle Buck's midday naps, forgetfulness and flatulence, this market has also -- despite current perceptions -- begun leaving clues as to its actual age.
Of course, your spouse likely has a pretty good idea as to which family events Uncle Buck should attend. So too should your investment consultant have a pretty good idea as to how to participate in market cycles. Because a good investment advisor consistently:
1) Assesses the market's range of possible future outcomes.
2) Game plans for the most probably scenarios.
3) Hedges against the worst case scenarios.
These tasks are critical and ongoing. For an advisor's primary role is twofold. First, take what the market giveth. That is, ride the bullish wave as much as possible while it lasts. Then to avoid the carnage when the bear inevitably sets in. Not that any investor will portage around all losses as the market drops. Even Peter Lynch was down sometimes. But a good advisor will ensure that your life doesn't change for the worse as the bear rips the bark off your neighbors' trees.
Bull markets typically last an average of four years. Placing the current market at a bit more than 150 percent of the average. Don't misinterpret. The last bear market was so disgustingly ferocious that we required an atypical response. And while we believe that the market could have more distance to cover towards its trend-line goal, we know that we are closer to the end than the beginning.
So, for those just beginning to dip their toes into the pool, or those looking to maximize what remains, where should one allocate capital in order to best leverage the current opportunity set?
Conventional wisdom says that the older a bull market becomes, the more one should overweight large cap stocks, which typically tend to be late-stage outperformers. Makes sense. As investors begin to shy away from aggressive growth plays at this point. Opting instead for companies with well-established revenue streams, deep market penetration and massive cash stockpiles. These companies would, in theory, be better prepared to weather any economic downturn.
But, such logic is akin to Hillary's claims that the technology behind her empty server remains a mystery. Complete poppycock.
The Value of Small & Midcap
Most investors currently sit in an underweight position to small and midcap stocks. Primarily because these last six years have seen large cap stocks perform well. Which should have been expected, given their decimation during the Credit Crisis.
Yet, when you consider the long-term returns of small and midcap equities, we believe it's a riskier proposition not to own them. Consider the last 15 years for proof.
Using the Russell 2000 Index, small caps averaged 7.4 percent per year from 2000 to 2014. During that same time frame, the S&P 500 large cap index returned 4.2 percent per year. Delivering 45 percent less than did the small-cap index.
Looking back even further, $1,000 invested in the Russell 2000 in 1979 was worth $29,742 by December 2014.That same 1,000 allocated to the S&P 500 was worth $21,468. The disparity? 2,874 percent gain versus a 2,047 percent return. Which makes that a Kim Kardashian (i.e. a no brainer).
Beyond the longer-term performance benefits, we recognize at least three other factors favoring small-cap equities at this stage.
First, the dollar has been, and will likely remain, strong. All of those large-cap multinationals doing business around the world will continue to be stung when it comes time to repatriate profits. Because translating profits from a weakening currency -- like the euro -- into a strengthening currency -- like the dollar -- simply means that overseas revenues are suddenly worth less. Many large caps, like our local Procter & Gamble, which does over 60 percent of its revenue overseas, will continue to be stifled by the dollar's growth until the trend reverses.
Small caps (and mid caps, to a lesser extent), do the lion's share of their business domestically. Thus avoiding all of the current earnings carnage being attributed to the strong dollar.
Second, small and midcap stocks are typically the beneficiaries of most of the mergers and acquisition (M&A) opportunities. As they tend to be popular acquisition targets by large strategic or financial buyers. Which often translates into buoyant stock prices, as the acquiring companies typically pay a hefty premium to complete the deal. At the current pace, the U.S. capital markets may reach $4.60 trillion in M&A activity. Marking 2015 as the best year for M&A activity on record.
Third, the upcoming rate-hike period will not be painful for small cap companies. Even though it oft has been in the past. Reason being? Small cap companies tend to be more leveraged than their large-cap peers. So when rates rise, their high levels of indebtedness translates into much higher interest payment costs on the highly leveraged debt facilities. Yet, the Fed has made it abundantly clear that future rate hikes will occur very gradually. As it does not wish to go from a zero-interest-rate policy to higher rates too quickly, cognizant of the adverse impact such a move would have on the economy. Accordingly, small cap stocks could have plenty of time to outperform.
Rise of Regionals
Another trend by which investors might benefit -- one closely aligned with small and midcap stocks -- will be to invest in small, regional banks and bank holding companies over the next few years. While these companies lagged their large cap peers over the last few years, they will benefit greatly as the Fed begins to raise rates. Allowing investors to climb the wall of worry in a rising-interest-rate environment.
During rising rate periods, regional banks can increase profits as long-term rates increase faster than do short-term rates. This enables regional banks to pay nearly nothing to customer savings accounts (something to which we've become accustomed), even as the banks make considerably more on commercial loans and mortgages. The disparity between what the lender pays and what it makes is called the "net interest margin," and it serves as a proxy for bank profitability.
As importantly, rising rates and improving real estate markets can serve as a catalyst for potential home buyers, who choose to buy sooner than later in order to avoid future rate increases. Banks benefit further as lending volumes increase. Not to mention the idea that rising rates can help to expand bank deposits, as people save more money in interest-bearing savings accounts as opposed to allocating capital to riskier assets.
Many regional bank stocks remain well below their 2007 prices. But they have begun to appreciate as the specter of rising interest rates takes hold. Year to date, the regional bank index has returned seven percent, even as the S&P 500 earned less than three percent.
The regional bank index offers significant upside from a historical price and a current valuation perspective. Today, it trades well below its 2007 high. And while the S&P 500 trades at a price-earnings ratio of 18.68, it sits at a considerable discount -- 15 times forward earnings.
Bond Buyers Beware
Asset allocation technique represents the art of overweighting areas slated to outperform while underweighting those deigned to underperform. That said, what areas of the market are poised to suffer?
Bonds and other fixed income instruments may soon become volatile. Accordingly, bond investors should know what they're getting into.
Investors purchase fixed income instruments for their conservative orientation. In addition to providing an income stream, bonds tend to buoy portfolios as markets get rough. This time around, however, that may not be the case.
There is an inverse relationship between interest rates and bond values. Accordingly, as interest rates rise, bond values fall. When the Fed begins to raise rates for the first time in eight years, bond values will correspondingly drop. If you own individual bonds, this will not be a problem. As you can expect to receive par value upon their maturity. If you own mutual funds, however, this represents an issue. As fund values will decline when bond prices drop. Which will precipitate the defection of investors, who do not sit tight as their bond fund falls in value. Which forces bond fund managers to sell assets that they might not have sold otherwise. Which locks in losses. Incites investor defections. And so on goes the catch-22. As the herd takes a difficult situation and makes it worse.
The answer? Bond indexes with premeditated trailing stops. Or, forgo the funds and buy the bonds directly.
Of course, not everything performs poorly when rates rise, In fact, there are a slew of businesses that have traditionally outperformed during such periods. Those include: property and casualty insurers like Travelers; payroll processors like Paychex and ADP; hardware and software companies like Apple, Microsoft and Cisco Systems; derivatives exchanges like CME Group; online brokerages like TD Ameritrade and Schwab; mortgage lenders like Wells Fargo; and rent-to-own businesses such as Rent-A-Center and American Homes for Rent.
On the fixed-income side, high-yield bonds, senior-loan portfolios, floating rate bonds and short-term Treasuries have typically outperformed their higher duration peers.
There also happen to be any number of businesses with a history of underperformance as rates rise. These tend to be stocks that pay a high yield to investors, so finding themselves with more competition as rate payouts rise in other investment categories. As well as companies whose success relies on consumers having access to low-interest financing. They include: highly leverage companies; telecom; utilities; REITs; blue chip dividend stocks; auto manufacturers; and home builders.
On the fixed income side, you'll want to avoid long-maturity, low-coupon bonds; 30-year Treasuries; fixed income mutual funds; and preferred stocks.
Alternative Investment Accolades
Late in the investment cycle, we advocate moving a portion of your portfolio to alternative investments. These include asset classes that will not ebb and flow directly with stock and bond markets. So, their low correlations to such markets enables them to perform admirably -- even when equities do not.
For example, in 2008, as the S&P 500 was on its way to a 39 percent annualized loss, the managed futures index was up 18 percent. The managed futures investments to which we'd allocated client capital fared even better. A rare saving grace during a chaotic time.
For accredited and qualified investors, the opportunities abound. Hedge funds, real estate, managed futures, mezzanine debt, commodities, precious metals, venture capital, private equity, raw land, structured solutions, market neutral. The list goes on. Even for investors who do not rank as accredited, there exists a variety of alternative investment opportunities that may provide some buoyancy to a portfolio. Even as equity markets sharply correct.
Never invested in anything but stocks and bonds? No problem. Nothing over which to become emotional. Emotion is the enemy of the investor. Better left for weddings and funerals. The good investor sells hope. Buys despair. Remembers that discipline trumps conviction. And always plans ahead.
Even in this nine-month trading range in which investors currently find themselves, we still inhabit a bull market. Trend lines point higher. And will continue to until the next shoe drops. Until we incur that precipitous decline that everyone has anticipated for six years now. Till then, reap what the market sows. Three months? Two years?
Eventually, we must prepare for the cycle's next stage. The termination of the bull. The onset of the bear. Designating as winners those prescient investors who began planning months before it reared its crusty, cackled main and roared its fearsome snarl in financial capitals around the world. Sending the herd, and the vulnerable animals therein, stampeding for cover.