March 8, 2020

This Nonsense is Making Sense

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The Bottom Line


While volatile and violent, markets have not been acting irrationally. Within the US, large-company stocks flush with cash have outperformed small company stocks short on cash, and offshore, international markets with better currency, valuation, and earnings fundamentals have outperformed our pricier US market. These facts may not add much comfort during such a jarring downdraft, but investors should find them heartening. Markets have properly discounted virus-linked recession risks by predictably discounting small caps. However, the outperformance of the emerging markets has surprised investors and could foreshadow a more durable period of outperformance to come.


The Full Story


Equity markets managed gains on the week despite all of the coronavirus commotion.  Economic releases portrayed underlying strength beneath the economy, but a surprise rate cut from the Federal Reserve drove sentiment and interest rates down to eye-watering lows.  (As an aside, if you have a mortgage, please stop reading and refinance RIGHT NOW!).  While the recent market mayhem may seem chaotic, it has actually been quite orderly.  In these modern markets, machines running groupthink algorithms can quickly push prices around as traders feast on volatility and technical activity.  However, viewed from afar, these movements, while occasionally overblown, have logical underpinnings.  For longer-term investors, big risk reorganizations like this can provide meaningful insights into the overall health of markets and the potential for returns to come.  Rather than debate and discuss physical and economic mortality risks this week, let’s take a clinical look at recent market reactions to assess selloff rationale and recovery prognostication.


PIcture 1


First, let’s examine reactions within the US equity markets.  The chart above displays returns across company sizes and investment styles.  At the bookends, large-capitalization growth stocks have fallen 2.9% year to date while small-capitalization value stocks have fallen 17.2%.  This exaggerated divergence makes sense.  If the US economy falls into a panic-inspired recession, cash becomes king, and small companies hold very little cash while large companies like Apple hold ocean freighters full.  Furthermore, stocks in economically cyclical industries like financials and consumer discretionary comprise 29% of the S&P 500 large-cap growth index, contrasted with over 51% within the S&P 600 small-cap value index.  Analyzing the size and style numbers alone, the US stock market reacted appropriately for the possibility of recession.


Next, let’s examine geographic returns.  This gets very interesting.  Before we can start looking at international markets, we must examine the US dollar.  Coming into the year, the US dollar appeared overvalued relative to other currencies.  The Economist maintains an index comparing the cost of a Big Mac in countries around the world to deduce currency over and undervaluation relative to the US dollar.  Here are the current Big Mac index currency value comparisons:


PIcture 2


Overall, to quote the Economist, “The Big Mac Index shows currencies are very cheap against the US dollar”.  Typically, in times of market stress, the dollar appreciates as fearful foreign money seeks safety within the US.  However, over the last month that has not been the case.  The DXY dollar index has fallen 4% in the last 12 trading sessions and now stands lower on the year.  In fact, the top in the US dollar index occurred back in December of 2016 after nearly a decade of uninterrupted gains.  Dollar cycles have significant influence over security prices worldwide, and while a weaker dollar may benefit US companies selling goods abroad, it also rewards US investors owning assets abroad.  Let’s see if this logic holds in the current environment.  Global stock markets peaked on February 12th.  Since then, the MSCI emerging market index has fallen 6.34%, the developed world ex-USA index has fallen 9.03% and the US stock market index has fallen 10.48%.  I am not asserting that the decline in the US dollar alone accounts for the outperformance offshore; other factors such as valuation and earnings expectations must also be examined.  From a valuation perspective, offshore equities look relatively cheap compared with US equities:


PIcture 3


The US trades at 18x forward earnings while the rest of the world trades for 13.7x, for a discount of 25%.  From an earnings perspective, analysts currently project earnings growth of 19.5% for US companies over the next two years.  This compares with 20.6% for Europe and 28.7% for the emerging markets.  These numbers will fall as the consequences of the coronavirus register, but they should fall somewhat proportionately given the global nature of the crisis.  To summarize, the combination of currency, valuation and earnings growth advantages have led to outperformance for offshore markets since global indices peaked on February 12th.  The atypical outperformance of offshore currencies and offshore markets during this time of stress may foretell continued outperformance should the stress recess.  If you believe in mean reversion, the chart below should tickle your contrarian senses.  I’ll end this discussion with the picture rather than a thousand words!


PIcture 4



Have a great weekend,



David S. Waddell 
CEO, Chief Investment Strategist 



Sources: GMO,
David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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