Labor Day may mark the end of summer, but the good times for the markets aren’t over, right?
Not correct! Or at least possibly wrong, according to GMO’s Jeremy Grantham, who believes we will see the beginning of the bubble burst with a small-cap sell-off.
This week on the charts also looks at the rise in the cost of durable goods as an alternative way of capturing the value factor that can be better than a traditional index.
Wiretapping
Did Jeremy Grantham’s “pessimism termites” attack small-cap stocks first?
In a recent interview with Consuelo Mack, the value veteran described how the technology bubble of 2000 burst. He said that “pessimism termites” first hit the most speculative stocks and then worked their way to the most believable (but still overpriced) stocks.
In another interview with Preston Pysh about two weeks ago, Grantham found that the S&P 500 had started outperforming the Russell 2000 in February and wondered if the “trust termites” like Pysh’s called, hadn’t started with small-cap stocks. While he said it could be a “false positive,” he was impressed that the small-cap index had declined since February 9th at this point.
Our chart starts on February 1st and you can see small caps jump for a few days to their highs on February 9th and then languish to this day as the S&P 500 continues its steady rise. Small caps are down less than they were when Grantham spoke to Pysh, but are still down.
Grantham believes the current market (not just stocks, but bonds, residential property, and some commodities) is in the bubble area and after that call will no doubt be on the lookout for termites. Time will tell if they have already started feeding on small caps.
Not cool
At his Jackson Hole conference last week, Federal Reserve Chairman Jay Powell said deflationary trends will continue. Not everyone is convinced.
It is too early to tell, but the table above could become Exhibit A if Powell’s thesis is defeated.
The first thing to say about this is that offshoring has worked spectacularly to make durable goods cheaper. Private spending on durable goods has been falling since 1995, not long after Ross Perot’s famous debate with Al Gore over NAFTA in 1993.
In fact, offshoring has worked so well in terms of bringing down prices that durable goods cost about as much in real terms as they did in 1980.
And since 2012 they have become even cheaper. That is, until April this year, when the line on the chart shows an upward bend.
The question investors are now asking is whether this post-vaccination recovery is the start of a lasting trend.
The pandemic exacerbated wealth and income inequality, so workers, combined with fiscal incentives, are demanding higher wages. The pandemic also resulted in product bottlenecks due to restrictions in the supply chain. The spread of Covid in developing countries around the world has made it difficult to sustain the production of many goods in such a way that, at least at the beginning of the pandemic, the question arose whether all of the offshoring had endangered US national security.
It remains to be seen whether companies will bear the higher costs of supply chain diversification. But investors are starting to wonder whether all of the cost reductions from offshoring that translate into lower prices have hit their floor in one way or another.
added value
The iShares MSCI USA Value Factor ETF (VLUE) is a smart beta fund that tracks an index that has the cheapest stocks in the same sector as the MSCI USA index.
That means it doesn’t have the sector weights of other value funds, which are usually heavily biased towards financials, energy, utilities and real estate, and little tech.
From inception to August 29, the fund generated an annualized return of 11.80%, 38 basis points more than the 11.42% return on the Russell 1000 Value Index.
However, VLUE suffered additional volatility along the way. It had a standard deviation of returns of 16.11% versus 14.31% for the Russell 1000 Value Index, giving it an overall slightly lower Sharpe ratio of 0.72 versus 0.76.
Accordingly, it fell 37.98% versus 37.85% during the Covid collapse from February 24 to March 23 last year, and lost a little more for the entire first quarter of 2020, 29.20% versus 26.73% for the Russell 1000 value.
The fund also underperformed the Vanilla Value Index during the growth recovery this year, returning 3.48% from April 1 to August 29, versus 8.51% for the Russell 1000 Value.
But if the value has moved, the fund has outperformed. During the revival in value from early October 2020 through late March 2021, VLUE saw a 40% increase versus a 29% increase for the Russell 1000 Value index.
Overall, this data suggests that despite its less heavy sector weighting, the fund appears to have greater exposure to the value factor, falls more when value is lagging and rises more when it shines.
