Since the end of August, equity prices in the US and abroad have trended mostly higher. One notable development during this period has been the resurgence of the small capitalization and value sectors of the equity markets. These riskier assets have come to life in concert with the rally by more visible indexes such as the S&P 500 and the Dow Jones Total US Stock Market Index (DJTMI).
While several benchmark indexes representing these riskier assets have moved strongly higher, especially during the past five trading sessions, we should note that they remain for the most part well below their most recent historical highs, which were posted in late August and early September 2018. The S&P 500 and the DJTMI are trading roughly 1% below their record closes, posted less than 2 months ago, in late July. The chart below illustrates Russell 2000 Value index closing prices over the past two years.
Since its most recent low, recorded August 23, this index of small capitalization companies whose share prices are relatively close to their book value per share, has risen more than 15%. This represents the largest sustained gain since the recovery from December 2018’s lows through February 2019, which was an advance of roughly 21%. These are significant numbers. Comparatively, the S&P 500 and DJTMI have each risen just under 6% since late July. Despite this recent surge, however, the Russell 2000 Value index remains more than 11% below its all time high posted at the end of August 2018.
Will the relative strength continue as this and other indexes benchmarking the small capitalization and value sectors of the equity market play catch‐up? We cannot know in advance but what this action could suggest is perhaps better understood by turning to the credit markets, where a sea change has occurred over the past two weeks as well.
First, a word about risk. Small capitalization companies and/or firms with cash flow or earnings problems generally must pay higher costs than more substantial companies when attempting to augment their finances, whether through equity or debt financing. Higher interest rates demanded by lenders, for example, reflect the perception and conclusion there is greater risk they will not receive full interest and principal payments, based on the companies’ balance sheets.
One of the problems faced by these “unexcellent” companies over the past year, especially, has been maintaining and accessing credit lines to supplement cash flows. As we have noted numerous times, the flattening of the yield curve in the bond market has, until very recent days, virtually eliminated any daylight between long and short term interest rates. In a banking system whose basic profitability is derived from the ability to borrow short and lend long, this situation has dissuaded banks from freely extending credit to all but the most financially stable companies.
Without the ability to build in a reasonable profit between the cost of funds and the market lending rate to compensate for greater repayment risk, banks have been reluctant to provide debt financing to firms at comparatively greater risk of default.
Over the past two weeks, the US Treasury yield curve has begun a moderate normalization as market participants anticipate a rate cut at this week’s Federal Reserve meeting. The yield for the 30‐year Treasury bond rose from a low of 1.93% less than two weeks ago to 2.33% on September 13. The long bond/T‐Bill gap has widened to more than 40 bps from essentially zero previously. Similar moves have occurred at intermediate points on the curve. In short, the yield curve is beginning to reverse existing inversions and revert to a more positive slope. Inversions persist, but with the prospect of at least a ¼% cut in the shortest rates imminent, the curve is starting to look more normal.
It may be a coincidence that companies with relatively poor balance sheets are beginning to draw investor attention at the same time interest rates are realigning and widening the yield spread between short and long term maturities. Or it may not. Only hindsight will fully inform us, but for the moment, rising interest costs appear to be viewed as a harbinger of somewhat easier credit for companies that need it most. The chart below illustrates yield changes over the past two weeks.
A ½% cut in the Fed Funds rate this week would create a positive slope in the Treasury yield curve. This development, should it occur, would be a significant step toward effectively unshackling the banking system. Amid the blizzard of statistics and concentration by the press and pundits on isolated numbers, taking a step back and listening to small businesses owners and consumers “on the ground’ is instructive. Two headlines caught our attention last week, both of which confirm that broad economic trends observed over the past 2+ years remain strong.
• Small Business Economy Remains Steady, Despite Doom and Gloom Narrative That’s Hampering Expectations1
• Americans Get Richer2
In the first article, the National Federation of Independent Business (NFIB) reports that its small businesses sentiment index dropped 1.6% in August, but that the level remains within the top 15% of recorded figures. The NFIB cites uncertainty rather than reduced activity or demand, fueled by recession predictions and/or accelerating trade conflict with China.3
News on September 13, that China is deferring additional tariffs on US goods suggests that this uncertainty may be somewhat illusory. Businesses continue to report difficulty obtaining workers while wages and other compensation continue to rise at over 3% year to year, keeping workers ahead of inflation, which is effectively 1.5% annually.4
The Associated Press published a two line “article” on September 10, that reported US household income has regained a level last seen in 1999 and that the poverty rate has fallen to its lowest level since 2001.5 The information was contained in a Census Bureau release.
Do recessions occur while Americans are experiencing rising incomes and their neighbors are escaping poverty? Perhaps. Statistics always look best at a top and worst at a bottom, but what about the equity markets? The ultimate leading indicator of economic activity appears to be flashing an “all clear” for the moment with investors’ appetite for more risk based on the expectation of future rewards growing, not shrinking.
We don’t make predictions. The markets evaluate all known information, emotions and predictions about equities or bonds and have proven to be highly effective discounting events well in advance. Regardless of this ability, however, markets are unpredictable. There will always be random, unforeseen occurrences that influence stock and bond prices.
A prime example is the attack on Saudi Arabian oil facilities this past weekend that has shuttered 5% of the world’s daily supply for an unspecified and at this writing, unknowable period. Crude prices jumped 15% in a single trading session but opened within 3% of their ultimate highs for the session. In other words, markets very quickly evaluated and adjusted prices to reflect the attack’s expected impact.
Short term price fluctuations and cherry picked statistics in the press are noise and should not tempt long term investors to abandon their discipline or plans. It is important to remember that the equity markets “price‐in” surprise news events almost instantaneously. Aside from sudden dislocations, market trends are generally in anticipation of future developments rather than what is on tonight’s newscasts.
1 “Small Business Economy Remains Steady, Despite Doom and Gloom Narrative That’s Hampering Expectations,” www.nfib.com, September 10, 2019.
2“Americans Get Richer,” www.wsj.com, September 10, 2019.
3 Op. cit., www.nfib.com.
4 “Employment Situation Summary,” www.bls.gov, September 6, 2019.
5 US Household income finally matches 1999 peak, while poverty rate hits lowest point since 2001,” Associated Press via www.washingtonpost.com, September 10, 2019."