Charts of the Month - March

The Advantage of Low Expectations

The market rarely tries to discern “good” or “bad,” rather its primary focus tends to be “better” or “worse.”

Recent financial results from FedEx and Lululemon illustrate this idea well.

Last month, FedEx reported that sales declined by 2% versus the prior year, making it six consecutive quarters of sales declines. Lululemon released results the same day and reported sales growth of 16%.

How did the stocks react? Probably not the way you expect.

FedEx shares were up more than 7% on the day, while Lululemon shares fell nearly 16%.

The lesson? Starting points matter.

FedEx traded at 13.2 times earnings prior to those results, while Lululemon traded at 34.6 times earnings.

The market’s expectations for each company were very different. Lululemon’s higher valuation came with greater expectations, and when they were not met, the market punished them.

Put simply, FedEx was able to step over a two-foot bar, while Lululemon bumped its knee trying to clear 10 feet.

Investment researcher Michael Mauboussin has written extensively on this concept, once mentioning:

“Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.”

This idea forms the beating heart of a strong investment philosophy: trying to identify gaps between price and value across stocks, sectors, and assets classes.

Assessing where expectations might be highest prompts a check-in on the Magnificent 7 (Mag 7).

Mag 7 Update

The Mag 7 defied gravity last year. Or at least something close to it.

The average Mag 7 stock was up 112% last year, on average, while the S&P 500 was only up 26%.

Needless to say, the Mag 7 was the predominant source of 2023’s market returns. But through one quarter this year, the results are less pronounced.

While Nvidia’s performance continues to be relentless—up 82% in the quarter—subtle cracks are starting to emerge across the rest.

For example, Tesla was the worst performing stock in the entire S&P 500 during the quarter, down 29%. Even Boeing—a company making headlines every day for the wrong reasons—was able to edge them out.

Apple was also negative for the quarter, down 11%. And Google, who returned 8%, trailed the S&P’s quarterly return.

Across the group, prices remain elevated—all seven have valuations above the S&P 500.

While these companies command the investment world's attention, it might be prudent to explore diversification opportunities elsewhere.

One of the areas that gets less attention—and expectations are likely lower—might be small caps.

Small Caps & the Three U’s

Contrarian investment decisions typically follow the path of "Three U’s": unloved, underperforming, and undervalued.

Small caps are certainly unloved—interest from active managers appears to be in a perpetual state of decline. Per Bank of America research, small caps represent only 3% of active portfolios, which is half the weight versus a decade ago.

The underperformance has been well documented. Large caps have trounced small caps, beating them in nine of the last 10 calendar years. Over the last 10-years, the total return for large caps beats small caps by greater than 120%. 

When you combine apathy and poor returns, it creates a potent cocktail for an asset to become undervalued.

According to Morningstar, small-cap stocks trade at an 18% discount to fair value, making them the cheapest U.S. asset class across the style box.

While many investors might dismiss small caps, the setup looks increasingly compelling.

Despite not performing as well as large caps, it might be flying under the radar that small caps broke out to new 52-week highs at the end of March.

As we’ve written previously, all-time highs are nothing to fear. In fact, quite the opposite.

A Quick Trip Down Memory Lane

Last month commemorated the 15-year anniversary since the market hit its low point following the financial crisis. The official trough came on March 9, 2009.

Through last-month end, the S&P 500 has returned 932%, or 16.8% annualized since that low.

If you had invested in the S&P when the market peaked in October 2007, that investment would have been more than cut in half by March 2009, a total drawdown of 55.3%.

However, by September 2017—within 10 years—you wouldn't just have recouped your initial investment but doubled it!

It’s a great reminder that time heals.

But the intent is not to pick a market trough, and then glorify the large returns that followed.

There are additional lessons we can tease out. For example, many investors who experienced that 50% drawdown likely capitulated along the way, selling as the market declined. It’s human nature—the pain of losses is often greater than the rewards that come from gains.

In effect, many didn’t experience the full impact of the subsequent decade-plus recovery.

Peter Mallouk—founder of Creative Planning—recently pointed out that achieving financial goals is a function of many things, one of which is “making sure you don’t blow up along the way.”

Thinking about that phrase—blowing up—we often associate it with an investment that goes to zero or loses a substantial amount. However, Mallouk pointed out that the S&P 500 returned 0% for the period from Jan. 2000–Dec. 2009.

If the S&P was your only investment and it returned zero for 10 years, that’s not a good way to achieve your financial goals, either.

Essentially, another avenue for blowing up potentially comes from poor asset allocation decisions.

Nobody had perfect sight in Jan. 2000 how the S&P would perform over the next 10 years. And the same is true in April 2024.

The best remedy we have is diversification. Which can be used as a form of risk reduction, allowing investors to spread risk around across a number of asset classes, rather than just U.S. large-cap stocks.

The 15-year milestone came and went without much conversation. But it’s a stark reminder of the resilience in markets, benefits of diversification, and the rewards potentially available to long-term investors.