3 Things Investors Should Know but Likely Don’t
“We are not what we know but what we are willing to learn.”
It hasn’t been too long since the feel-good first quarter ended. Yet, investors’ prior confidence regarding the prospect for an economic soft landing has rapidly dissolved into doubts. Hotter than expected economic and inflation data have pushed anticipated Federal Reserve (Fed) rate cuts further out, resulting in surging yields. Add a mid-April liquidity squeeze, a tenuous start to earnings season, and rising tensions in the Middle East, and risk assets are off to a bumpy start in Q2.
Still, there’s a lot for investors to like about the outlook for risk assets. The economy is expanding, not contracting. Inflation is moderating, albeit not in a straight line. The labor market is strong, defying expectations that it would be weakening by now. The Fed’s tightening cycle is over, and the next policy moves likely include rate cuts and a slowdown in quantitative tightening. Government spending will continue to stimulate the US economy, especially headed into November’s election. Corporate earnings are growing, and profit margins are fat. And consumers are spending generously on goods and services.
As a result, it’s difficult to envision anything too apocalyptic disrupting capital markets over the next few quarters.
But April’s turbulence, coupled with this still-constructive backdrop for risk-taking, does point to an increasingly complex investing environment. Shrewd investors hoping to beat the market must continually look beyond the lazy narratives captured in many financial news stories. That is, when scanning today’s headlines, investors could reasonably conclude that US large-cap stocks continue their performance dominance over mid- and small-cap stocks, market returns remain concentrated in the mighty Magnificent 7, and yields on long maturity Treasurys will plummet once the Fed begins cutting rates.
But investors might be surprised to learn three things:
- Small- and mid-cap stocks have outperformed large-cap stocks over the past five months.1
- Market concentration and the Magnificent 7 are myths so far this year.
- Since the Fed’s last rate hike in July, long-duration Treasurys have delivered negative performance — for the first time ever.2
What could these three unknowns mean for markets and investors in the second half of this year?
David Defeats Goliath: Look to Mid- and Small-Cap Stocks
The most recent low for the S&P 500® Index occurred on October 27, 2023 at 4,103. It happened right about the same time that the 10-year US Treasury yield breached 5%, briefly touching a 16-year high.3
The rally in risk assets since then has been at least partially driven by a change in the Treasury Department’s refunding schedule that favors short-term bills over longer-term coupon issuance, as well as by the Fed’s unexpected mid-December dovish pivot which introduced the possibility of future rate cuts for the first time since the tightening cycle began back in March 2022. This powerful one-two combination helped bring the 10-year US Treasury yield down from 5% in late October to less than 4% by the end of 2023, sparking a massive rally in risk assets.4
Lost in all the excitement is the fact that since the October 27 S&P 500 low, mid-cap (S&P MidCap 400) and small-cap (Russell 2000) stocks outperformed large-cap stocks (S&P 500) through the end of the first quarter.5
Investors’ hopes that cooling inflation would allow the Fed to aggressively cut rates without causing damage to the economy — the so-called soft landing — fueled the meteoric rise in mid- and small-cap stocks at the end of last year. In fact, small caps had their best December performance in history and their best month versus large caps since February 2000.6
But, more recently, hotter than anticipated inflation data have raised doubts about the Fed’s ability and willingness to slash interest rates this year. This has enabled large-cap stocks to wrestle back year-to-date performance leadership from mid- and small-cap stocks.
The biggest takeaway for investors from all this back and forth is that greater clarity about the timing of Fed rates cuts could reignite the hiding in plain sight mid- and small-cap rally. For investors who expect the Fed to cut interest rates in response to falling inflation later this year, now might be a good time to consider investing in relatively inexpensive mid- and small-cap stocks.
Feeding the Multitude: Market Leadership Is Broader Than Headlines Suggest
Market concentration driven by the performance of the Magnificent 7 is possibly the laziest and most overused stock market narrative. It may have been true last year, but it’s a myth so far this year. Extrapolating the trend is a common investor mistake. All over the world, in benchmarks built using market capitalization as the weighting methodology, like the S&P 500, the biggest companies have an outsized influence on both risk and return. That’s not news.
What might be news to many investors is that the Technology sector is only modestly beating the S&P 500 so far this year. And investors would be downright shocked to know that Technology has been the second-worst performing of the 11 sectors over the past month.7 Communication Services, Energy, Financials, and Industrials are the only sectors to outpace the S&P 500’s year-to-date return.8 Outside the performance of the Communication Services sector, that’s hardly a ringing endorsement for the Magnificent 7.
Taking it a bit further, large-cap growth benchmarks do have a modest performance advantage over value indexes, but it’s not the runaway it was last year. As noted previously, mid- and small-cap stocks actually outperformed the S&P 500 since its most recent low from late October through Q1. And, globally, stock market benchmarks from Europe, Japan, and many other places have reached all-time highs this year. Evidently, global stock market performance results this year are far broader than the Magnificent 7.
And for market participants able to invest beyond publicly-listed stocks — in the true global market portfolio — there have been winning investments in precious metals, commodities, real estate, cryptocurrencies, and private assets.
In a globally diversified investment portfolio, market concentration led by the Magnificent 7 is a myth not only this year, but every year.
Doubting Thomas: Adjust for History-making Negative Returns on Long-term Treasurys
Investors are witnessing bond market history, but they likely don’t know it.
For the first time ever, long-duration Treasurys (Barclays Capital 20+ Year Treasury Index) have delivered a negative return 10 months following the last Fed rate hike from late July 2023.9 Long-duration Treasurys have suffered a significant drawdown since August 2020 and have produced a flat return since the end of 2012.10
The lack of protection from investing in long-duration Treasurys, especially in anticipation of Fed rate cuts later this year, is baffling.
Yet, this poor performance has not deterred investors from adding billions of dollars to funds that track the Barclays Capital 20+ Year Treasury Index. Ever since the 10-year US Treasury yield breached 4% back in late September 2022, investors have been eager to extend maturity in fixed income allocations.
Duration measures a bond’s price sensitivity to changes in interest rates. The longer the maturity, say 20+ years, the more sensitive the bond’s price is to changes in interest rates. A bond’s yield reflects growth assumptions, inflation expectations, and term premium. When yields fall, bond prices rise.
After the Fed aggressively raised interest rates from March 2022 to July 2023, many market participants predicted that economic growth would slow, inflation would fall, and the Fed would have to respond by cutting interest rates. That’s the typical pattern. Purchasing long-duration bonds at prevailing yields would enable investors to benefit the most from falling interest rates.
But here’s the rub — economic growth has been much stronger than expected, inflation remains elevated, and the Fed is in no hurry to cut rates in the current environment. Rather than falling, rates have risen, producing losses for long-duration bondholders. This isn’t typical, it’s unusual.
Investors may eventually be proven right when economic growth moderates, inflation cools, and the Fed begins cutting interest rates in response to the changing landscape. But nobody knows for sure if or when that could happen. Meanwhile, the Treasury Department needs to issue more debt to fund ballooning government deficits at a time when the Fed and other traditional purchasers are buying fewer Treasurys, putting additional upward pressure on yields.
Almost everyone expects, and is positioned for, lower interest rates in the future. That’s exactly why it may not happen.
Investors should hold on tightly to high quality shorter and intermediate maturity bond investments with generous yields. And, if the expected soft landing or even a no landing materialize, allocations to credit could result in a yield enhancement for investors willing to accept the additional risks.
What Are We Willing to Learn?
When it comes to making investment decisions, market participants must always allocate capital using incomplete information. As we wait for the Fed to cut rates and the anticipated soft landing, it’s critical for investors to look beyond today’s lazy headlines and tired narratives to discover new information and curious relationships.
By digging deeper into the tasty, spoon-fed anecdotes of large caps’ dominance over mid and small caps, Magnificent 7 market concentration, and protection of long-duration bonds, we’ve exposed these half-truths for what they really are, noise. And more remain hidden, waiting to be uncovered.
Successful investing isn’t about what we know or don’t know. It’s about how far investors are willing to go to learn something new. Something that may give them a comparative advantage in building diversified investment portfolios to better meet their long-term financial goals and objectives.
So, what do you know that others don’t? Care to share? Happy learning, everyone!
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