Supportive Fiscal Policies See US Reach All-Time Highs
The turning point is caused by the reverse of the interest rate cycle which is repositioning itself to where it was at the end of World War II, after 40 years of falling rates.
The implication of this change is that investors should reposition themselves in the best performing market segments over the long term.
A little bit of the road: why 2020 was the year of the small cap
The problem, however, is that these areas have been out of favor for so long that many participants today don’t even know the names of the stocks, let alone remember when they were the place to be.
Long-term evidence now leads us to reap value from US small caps.
Why the United States?
First of all, then, why should we go to the United States when they already represent 55.9% of the world market and are at an all time high?
The answer is simply that it has been and remains the best performing major market according to the research of a number of leading economists: Dimson, Marsh, Staunton et al.
Let’s not dwell on it. The reason is also simple. The rule of law and corporate governance correlate with stock market returns.
After landing in the United States, why should we be small? The answer is they work – as evidenced by the fact that the little ones outperformed large stocks, government bonds, T-bills and inflation over almost 100 years between 1926 and 2017.
Smaller stocks outperformed amid rising interest rates after WWII. After nearly 40 years, they peaked in 1983 and their outperformance was closely linked to the interest rate cycle. They outperform when rates rise because both are indicative of a decent economy.
In times of low growth and falling rates, the small ones can move a little better than the market. In times of weak growth and very low interest rates, small underperformance as occurred from 1926 to 1938 and also in the present century.
To continue, the main predictor of outperformance is value. It eclipses the two previously mentioned heroes – the United States and small business – because according to Dartmouth data it has outperformed growth by a factor of 17 since 1927.
Industry Voice: Sustainability is the key to value creation
It comes as a surprise, then, that this wonderful asset class has underperformed the world since 2004. In the United States after the global financial crisis, the value went from 100 to 320 while the growth went from 100 to 550, and although this deficit looks dramatic, it will soon be built up when value picks up.
Cognitive dissonance is the reason value outperforms. Not only do value stocks tend to improve faster than expected, but they can also sometimes turn around and be re-valued as growth stocks.
When the reversion occurs, all of the precise discounted cash flow valuation methods, which give analysts their so precise target prices, fly right out of the window.
The problem is, the discovery of stock prices is done through the humans who buy and sell. As humans, we have evolved to see saber-toothed tigers hiding in tall grass, patterns in the sky that we call astrology, and patterns in stock charts that we call Japanese candlesticks.
We place too much weight on our abilities to extrapolate into the future and then change the narrative to maintain our self-esteem in a dangerous world when we get it wrong.
Having established what wins, why now? It’s all about the interest rates. This has been the biggest cycle.
The all-time peak came in 1981 when Paul Volcker, Chairman of the Federal Reserve from 1979 to 1987, decided to beat inflation at all costs for jobs and raise short-term rates to 20% , inaugurating 40 years of monetary policy.
Interest rates bottomed out in 2020 with a third of sovereign debt guaranteeing you a negative return if you held it. A huge historic low.
They turned around when current US President Joe Biden decided to defeat unemployment at all costs against inflation, ushering in a return to fiscal policy.
Both small and US market stocks are starting to outperform again after reaching their worst position relative to growth and large caps since 1904. After this greatest of cycles, the elastic band is stretched to historic levels.
When you think the amazing changes in technology make things different this time around, remember that their valuation increases were created by putting interest rates lower in the models and at 0%, you can get a endless valuation and never having to make a profit at all.
Remember, too, that monopoly policy eventually catches up. John D. Rockefeller’s large-cap Standard Oil controlled 91% of US oil production and 85% of oil sales, its peak. In 1911, it was dismantled.
Richard de Lisle is manager of the VT De Lisle America fund