Barbells Will Strengthen Your Portfolio

On the assumption that my bifurcated earnings season produces underperforming mid- and small-cap sectors (resulting in the long overdue stock market correction), one very attractive investment strategy to employ while waiting would be a barbell approach with large and mega cap on one side and emerging markets on the other. The Smids (small and mid cap) would be held to a minimum.

This strategy covers both the short and near-term bases and should enable performance participation as the large- and mega-cap part of the equation benefit from the global growth story (which is where the growth actually is) and weak US dollar. The emerging portion also benefits from the global growth story while also providing the beta trade.

The beta trade has been the place to be throughout this bull rally (see chart), frustrating those who predicted and preferred the quality (and, therefore, lower beta) trade.

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As the accompanying chart makes quite clear, the Smids and micro cap bested the large (SPX) S&P 500 and mega (OEF) S&P 100) by a considerable margin since the early 2009 March low. However, since mid-September the two groupings (large versus smaller) have experienced a reversal of fortune, as the following chart illustrates.

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Some would argue that the underperformance of the Smids and micro cap is a normal course of action during choppy market periods. That may be the case and time will tell. However, my thesis is that the underperformance is due more to a slow recognition that second- and third-tier (on down) sectors of the market, which are more highly tied to the US economy, are about to experience price and profitability pressures for reasons noted in last week’s article “Big and Small Companies: Divergences You Must Follow”

Now, compare various emerging market indices over the same two time periods.

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A substantially better performance over both time periods compared to the Smids and micro-cap sectors. Finally, the beta dimension to this comparison can be seen in the following table:

Moreover, the moderately higher beta in the emerging markets issues produced a risk-adjusted return greater than what was achieved by the Smids and micro cap.

Investment Strategy Implications

As I noted in last week’s article,

Big and Small Companies: Divergences You Must Follow

What I'll be watching for very closely will be two factors:

1. Will the more US-centric mid- and small-cap companies produce earnings this and next quarter to warrant the enthusiastic conclusions reached by the bottom-up analysts?

2. Will the stock-market performance of the mid- and small-cap sectors confirm or diverge from the large-cap sector should stocks continue to make new highs?

My money is on the non-confirmation-high scenario rooted in a bifurcated earnings season. The implications of a bifurcated earnings season is a hollowing out of the US economy with big, multinational companies winning while US-centric companies (along with the US worker) losing.

Because stocks are fully synchronized and have produced no price divergences (thereby limiting the downside to an “air pocket” drop), investors would benefit from the barbell mix of mega and large with emerging markets while the stock markets sort out the implications of 2009’s third-quarter earnings season.

When (not if) stocks do produce a divergence (thereby signaling the high likelihood of something more than an “air pocket” drop), the barbell mix would need to be adjusted, as all markets will experience the pain (as in a greater than 10% correction). And high beta markets will likely suffer more than most.

Until that time, the barbell mix appears to be the most prudent and potentially profitable way to manage the portfolio mix for actively managed portfolios.

Editor's Note: This article originally appeared on Minyanville.