Charts of the Month - November

Diversification Always Means Saying Sorry

Dump trucks of ink have been spilled lamenting the benefits of diversification.

Why? Because it’s a practical investment concept, and its merits are applicable to more than 90%—at least!—of investors.

But one item that gets less attention: If you preach diversification, you often spend a lot of time apologizing.

The reason? Owning a collection of assets means there’s always going to be a few that aren’t moving in the right direction.

There’s a famous story about Boston Celtics legend Larry Bird walking into the locker room before a 3-point contest and sarcastically asked his competitors, “Who’s coming in second?”

Bird went on to win his third-consecutive three-point contest a couple hours later.

The analogy to equity markets: U.S. large-cap stocks have been carrying themselves like Larry Bird. Everyone else has been playing for second.

Through November, U.S. large-cap stocks are up nearly 21% for the year. If you isolate growth stocks inside large cap, the number is even more pronounced, up nearly 37%. Meanwhile, no other major equity asset class is even close.

This has been true for much longer than just 2023.

When you see these numbers, doubt creeps in. What’s the point of owning anything else?

The best thing that can be said: when in doubt, zoom out.

Markets have been operating for a lot longer than 10 years. The historical returns of other asset classes have been competitive over longer cycles.

There are quarters, years, and even cycles where diversification doesn’t feel good, but over long periods of time, it’s relentless.

This is a feature, not a bug.

Surveying the market, there are many areas worth diversifying into, but one worth highlighting: small caps.

Small Caps

When thinking about what drives stock prices, there’s an old saying:

“Randomness dominates the short-term, valuation dominates the medium-term, and earnings dominate the long-term.”

We can’t control for randomness.

We can try to forecast earnings, but it’s not easy.

However, the one factor we can be very diligent about is the prices we pay, or valuation.

That leads us to small caps: current prices—valuations—could be signaling future success. Prices have hardly been cheaper.

It’s not just valuations, either. The dominant run by large companies has led to some extreme disparities.

Apple and Microsoft both have market caps larger than the combined market cap of all the stocks in the Russell 2000!

Additionally, small caps as a percentage of the total stock market are at their lowest levels since the 1930s.

Now, valuations are never a silver bullet. Certain asset classes become cheap for a reason. The asset class comes with caveats, including:

· more than 40% of small-cap companies are not profitable

· greater sensitivity to the economic cycle

· higher amounts of leverage

The last point—small caps have more debt than large caps—is worth highlighting further. This seems to be a significant reason small caps sit at their current valuation levels, given the uptick in interest rates.

Using data from FactSet, 49% of the total debt held by small caps is floating rate. For large caps, less than 10% of their debt is floating rate.

Why is that important?

Put simply, the interest payments on debt for small-cap companies has been adjusting higher—a competitive disadvantage—while large-cap companies are holding mostly fixed-rate debt, which means their debt payments are not rising.

Are there other reasons investors might be ignoring small caps and favoring large caps?

Of course, but the unfavorable debt structure—in the face of rising rates—has been a major hindrance.

The good news is this hindrance could soon flip.

As we discussed last month, the market is pricing in rate cuts starting in March of next year.

This could be an important driver for small caps and potentially help close some of that valuation gap.

Deflation?

If the word inflation charged royalties based on usage, the monthly mailbox money would make the cast of Friends jealous.

Inflation’s been a topic the entire globe has been wrestling with—the Google search results reached a fever pitch in recent years.

But the trend in inflation has been slowing for some time. It peaked last summer at 9.1% and has continued to trend lower—now hovering in the 3% range.

There’s been some interesting comments recently from a few large global retailers and a manufacturer that indicate we might need to learn a new word.

The word? Deflation.

A sample of recent commentary includes:

Wal-Mart: “We may be managing through a period of deflation in the months to come. And while that [may pressure our margins], we welcome it because it's better for our customers.”

Home Depot: “The most important observation we've made is that the worst of the inflationary environment is behind us.”

John Deere: “This was the first quarter in a number of years where we've seen production costs actually become deflationary and serve as a tailwind for our business.”

Using data from Adobe, there’s been a significant trend in falling prices across several major retail categories.

Will falling prices ultimately stick? It’s too early to tell, but consumers are hardly noticing.

The Consumer

The average American consumer is expected to spend more than $1,600 this holiday season, up nearly 14% versus last year, according to a Deloitte survey.

Obviously, a survey is a collection of expectations—it guarantees nothing.

However, we are already collecting hard data on consumer spending from Black Friday and Cyber Monday.

The quick summary: Consumers are not feeling bashful. In fact, they’re breaking records.

Data from Adobe Analytics on Cyber Monday paints a clear picture:

“The $12.4 billion spent on Monday topped last year’s $11.3 billion on the same day. The rise was broadly driven by new demand and not simply higher prices, and in fact the number would have been even higher if the figure was adjusted for inflation—making it the biggest online shopping day of all time.”

And shopping is not the only area seeing a surge. The Sunday travel day after Thanksgiving was the busiest day ever (again for emphasis: EVER!) at U.S. airports.

According to TSA data, more than 2.9 million people were screened at security checkpoints that day.

A couple days of strong data is not indicative of where things will be in a few months, but it certainly is a surprise given where we thought things might be headed at the start of the year.

One reason the consumer might be proverbially surprising to the upside? Unlike small caps, almost 90% of all U.S. household debt is locked in at a fixed rate, according to Federal Reserve data.

This data is surprising. There’s been plenty of stories written about soaring mortgage rates, auto payments, and credit card debt pinching the consumer.

But broadly speaking those pockets of pain likely don’t represent the entire story. And much of the figures being reported are consistent with the longer-term trends we’ve been discussing in recent months detailing a resilient economy, strong employment, and a stock market that continues to chug along.