Markets in Review
Equity markets continued their upward climb during the second quarter of this year. Following a solid first quarter, the S&P 500 Index returned 8.17% during the second quarter with most of those gains coming in April and June. The tech-heavy NASDAQ performed well this quarter with a 9.49% gain that was also primarily earned in April and June. The Dow Jones Industrial Average ended Q1 up 4.61%.
Figure 1: Price Performance through 6/30/2021
In contrast to the first quarter of 2021, a rotation out of smaller capitalization companies and into large and mega-cap stocks appeared especially towards the end of this quarter. This was particularly noticeable for value and dividend-based stocks.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, was up 4.05% in Q2. Furthermore, value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, did not perform as well as growth and technology especially in the month of June. This performance is noted with the Russell 3000 Value Index returning 4.68% for the quarter.
We do not believe this indicates the end of the trend that dominated both Q4 of last year and Q1 of this year. It does suggest that mega-cap technology, growth and momentum securities could attract investors at certain times as the market evolves this year. However, we still feel that cyclical and value assets should continue to outperform on a relative basis throughout the ongoing recovery and reopening from the pandemic.
For almost a decade, small-capitalization companies, and especially those with a value bias, had underperformed large-capitalization companies. This is common in late-stage bull markets where investors are attracted to the biggest companies with the largest remaining growth potential.
However, due to most COVID restrictions being lifted and broad vaccination programs, the economy has put the pedal to the metal again. This reopening opportunity has investors clamoring to buy those small-capitalization and value bias companies because they were hurt the most in 2020 and now offer the greatest upside potential. This rotation is typical during the early stages of any new business cycle, but especially pronounced due to the pandemic shutdown last year.
The Bloomberg Barclays US Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, was up 1.83% for Q2 although it is still down -1.60% for the year. Yields, which move in the opposite direction of bond prices, increased sharply throughout the first quarter of this year. However, the second quarter saw a moderate drop in yields again due, in part, to the outlook for continued monetary policy support and questions about improving economic growth prospects.
Is There Still Value in Value?
As mentioned above, smaller companies and value-based stocks tend to perform best in a rebounding economy. Many of the traditional cyclical and value sectors (e.g. energy, financials, industrials, and materials) that have been underperforming for years recorded strong performance in Q1. Investors hope government support will jump-start and maintain a strong economic recovery for years to come.
However, there was a clear reversal especially towards the end of the quarter as value underperformed growth by the most in twenty years. In the chart below, we have plotted the spread between the monthly performance of the Russell 3000 Value Index and the Russell 3000 Growth Index. When value outperforms growth, the monthly return spread differential is positive. When growth outperforms value, the monthly return spread differential is negative. As you can see, although there were a few other monthly periods that came close, we must look all the way back to April of 2001 to find a period where growth outperformed value as much as it did in June of 2021.
Figure 2: Value vs. Growth Performance
As mentioned above, we believe this is a transitory situation rather than an indication that value companies will continue to underperform for years to come. First, this part of the market experienced a significant rally as investors became excited about the elimination of pandemic restrictions and the economic growth prospects ahead. It is only natural after such a significant rally that the market would take a pause or experience a brief pullback.
Second, fixed income investments also experienced a technical bounce this quarter which sent yields lower again. As interest rates decline, growth companies typically outperform their value counterparts due to a variety of factors. Third, concerns about inflation and the Federal Reserve Bank’s response to a potentially overheated economy put a damper on things. Finally, the recent spread of the delta-variant of COVID has also caused investors to recalibrate their expectations for economic growth.
One must stop and consider how different the world looks now than just six months ago. Vaccine approvals, businesses reopening, and pandemic restrictions mostly lifted in the U.S. caused investors to get possibly overconfident that COVID was completely behind us and let the good times roll again. So, it’s only natural that at the sign of a few bumps in the road to recovery, we’re seeing a temporary pullback in value investing.
That said, we believe this too is an overreaction as we are clearly still in the early stages of economic recovery from the pandemic with many areas of the globe still lagging far behind. Earnings season is underway as I write this and all indications are that companies are poised to report record surges in profit. The Fed appears ready to continue its relatively dovish stance with more supportive monetary policy for a while longer, and Congress seems like they are still working hard on fiscal stimulus packages, although maybe smaller than initially planned.
In short, we firmly believe there is still value in value investing. The recent pullback should not be ignored, but we think that there are still many companies that were decimated by the economic shutdown last year and have great prospects as the world continues to reopen. However, it is possible that a slightly more balanced approach is appropriate where portfolios include both value and growth companies during this phase where many uncertainties remain.
Risk Factors Still Exist!
With the markets continuing to make record highs, one might think that value vs. growth investment decisions are the only thing to be concerned about. Nothing could be further from the truth!
As we discussed last quarter, a significant risk factor to economic recovery and the bull market is proposed tax increases. While the intended purpose of tax increases is to fund infrastructure spending, tax policy is largely being driven by the politics of wealth redistribution. The problem with tax increases is that they can offset the positive economic growth effects of infrastructure spending.
Although the past quarter saw yields drop, we expect to see rising interest rates again in the near future which will create another huge risk factor for the economic recovery as the cost to finance debt starts to rapidly increase. This is true for both risky corporations with huge balance sheet liabilities that were funded at low rates over the past 10+ years, as well as federal and state governments which must support ever increasing budget deficits.
Furthermore, those mega-cap technology growth companies continue to trade at extreme valuation levels and it becomes reminiscent of the dot-com bubble twenty years ago. In general, many investors appear to be intoxicated with expectations that markets have nothing but upside ahead. As we know, many significant declines occur at these very moments of market euphoria and overconfidence. Extreme price events usually catch investors by surprise and cause everyone to go running for the door.
While investing may continue to look easy for a while longer, we have learned the hard way that investing is never easy. The most important path to investing success is to preserve your capital by taking small losses during volatile periods and in bear market cycles. Avoiding the types of portfolio crushing large losses that happened in the past, and will absolutely happen again in the future, allows investors to be well-positioned for the next bull market growth cycle.
Limiting future losses may be more important this time around because those losses may be larger than historical norms suggest. We have had unprecedented monetary policy and government support of markets for more than a decade and rationalizing the excesses may be very painful.
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
Past performance does not guarantee future results.
The views presented are those of Steven Van Solkema and Don Schreiber, Jr. and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.
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Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return.
The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.
The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors.
The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ.
The Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe.
The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index.
The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.
The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.
The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000.
The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000.
The Barclays U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index.
The Barclays Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers and includes the performance effect of income earned by securities in the index.