As the last rally was nearing its end, I shared my view that the returns on stocks in 2009 would be correlated to their debt load. I continue to adhere to this theme. While many of the rallying stocks are stocks that were hammered hard in the downdraft that ended 3/6 are heavily leveraged companies that were too oversold and now perhaps have attracted either short-covering or buying from those who believe that the situation isn't quite so dire, stocks with better balance sheets are doing better overall, even in the rally, as I shared recently.
I have also shared a perhaps controversial view that Small-Caps should provide relative outperformance, which is out of character for a bear market. I first explained my reasoning in late January, which proved to be a little early, but has been marginally correct now, with the S&P 600 up 5.4% compared to a 3% rise in the S&P 500. Of course, the market has rallied, so we will have to see how it plays out when (if) the market declines again.
I like to look every now and then at the percentage of stocks trading above their 200 day moving average to get a sense of overall trends. As I did it this morning, I was a little surprised by what I found, so I spent some time reviewing it. The S&P 500 is trading 13.6% below its 200dma, but 17% of the stocks are trading above it (not too surprising). The Russell 2000 is trading 14% below its 200dma, but 23% of these small-cap names are trading above their moving averages. Here is what it looks like across a variety of indices ():
This is further evidence that companies with better balance sheets are trading better than those with worse balance sheets. For every single index in the table, the median net debt to capital ratios are lower for the stocks trading above the 200dma, in most cases quite significantly. Note also that the NASDAQ 100, which is up over 10% YTD, has extremely well capitalized members compared to the broad market. Clearly, while not the only factor that separates winners from losers, the balance sheet seems to play a significant role.
Small stocks are still lagging larger ones year-to-date despite the better balance sheets. I believe that the diminishment of the hedge fund community and the increased risk-aversion from those who remain as well as mutual fund outflows explain this apparent divergence. Small stocks have narrowed the performance gap sharply recently, are better capitalized and offer better valuation in terms of P/TB and only slightly higher PE ratios. As you can see in the chart below (), it is difficult to understand the relationship between large and small stocks, as it isn't clear that the economy or the direction of stocks drives it.
It is tempting to look at the chart above and conclude we are "near the high" end, but I believe that would be a mistake. I wish I had data that went back further (like Ibbotson), but I started in 1987, which is the inception of the Russell 2000. Note that small stocks were clobbered relatively in the Crash of 87. Note also that they performed relatively worse in the 90-91 recession, but recovered over the next few years as the Fed eased.
Small stocks were hammered again in 1998 as a global liquidity crisis flared up followed by a massive bull run with everyone crowding into a handful of large and becoming larger companies. Small-Caps outperformed sharply over the next seven years, which included a recession and a bear market, as the mega-caps saw their valuations return from the stratosphere. As the economy and the stock market improved, smaller companies continued their superior performance. I believe that this was a function of the relative growth advantage that they had over larger companies in a maturing economic cycle. Small-caps and large-caps moved together roughly until a surge in 2008 followed by a stunning correction. The surge in small-caps was due to the credit markets contracting which had the perverse effect of forcing certain funds that were short to cover. Subsequently, small-caps dropped sharply relative to large-caps, which is typical in a liquidity crisis or recession.
So much for the history lesson! I think that we don't really know all the factors that drive the relationship over time. I went back and looked at the level of or direction of Fed Funds and the level of corporate spreads and didn't find a clear relationship. We know that relative valuation and perceptions of growth can play a role. We are currently in an environment that is unprecedented in most of our lives. We have already seen the liquidity impact that led to some underperformance, but it wasn't nearly as bad as any other time post-1987. Small-caps are already defying the normal tendencies to get hammered relatively at times of recession. In the past 4 years, the relationship has been very stable. In fact, I don't see another period on the chart with as much stability.
Investors are really just waking up to the notion that our economy will most likely be very weak for quite some time. Credit spreads remain inordinately high. Last year, the concern over bad balance sheets was really limited to maturities in the coming year only, but many are beginning to realize that addressing even longer-term debt will be challenging and costly. Larger companies tend to have higher relative debt loads, and I expect that we will see their equity valuations suffer relative to smaller ones in general. It's not the size but rather the indebtedness that is what counts. Small companies with excess capital are plentiful - 42% of the R2000 has no net debt compared to just 23% of the S&P 500.
So, 3 1/2 months into the year and the world not apparently coming to an end thankfully, small stocks are down slightly more than large ones. I continue to expect that the reversal that began in November but was tested in January and March will continue, even if the rally doesn't. I believe that investing in companies with good balance sheets will be rewarded no matter what the market cap, but especially in smaller ones.
Disclosure: No position in any stock mentioned