Laggards Among Leaders

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Includes: BAC, DIA, GILD, GM, IJH, IJJ, IJR, IJS, IVE, IWC, IWM, IWN, IWV, JPM, KRE, QQQ, SPY, WFC, XLF, XLK
by: Eric Parnell, CFA

Summary

Suppose you are a reluctant bull when it comes to stock investing.

You have doubts about the fundamental forces that have been driving stocks higher in recent years, yet you also recognize that the Fed could push the market higher indefinitely.

You want to have exposure to the stock market, but you also recognize the risks that come with buying stocks today with valuations at historical high levels.

A strategy to overcome these various obstacles is to seek out the laggards that exist among the leadership that is the U.S. stock market.

Suppose you are a reluctant bull when it comes to stock investing. You have doubts about the fundamental forces that have been driving stocks higher in recent years, yet you also recognize the fact that the market could continue to rise indefinitely thanks to the continued support of the Fed. As a result, you want to have exposure to the stock market, but you also recognize the risks that come with buying stocks today with valuations at historical high levels. A strategy to overcome these various obstacles is to seek out the laggards that exist among the leadership that is the U.S. stock market.

Setting The Baseline

For the purposes of this discussion, it is worthwhile to first establish the baseline for what has represented U.S. stock market leadership during the post financial crisis period.

While the Dow Jones Industrial Average (NYSEARCA:DIA) and the NASDAQ Composite (NASDAQ:QQQ) are the measures that get mentioned most in the general news media, the S&P 500 Index (NYSEARCA:SPY) is of course the premier stock benchmark for those that operate in investment markets on a daily basis. After all, a market cap weighted index of 500 stocks is a lot more useful for monitoring how the stock market is doing on any given trading day than a price weighted index of 30 stocks or an index that tracks the performance of only one of the two major U.S. exchanges and is weighted more than half to one single sector in technology (NYSEARCA:XLK).

So the S&P 500 Index is the benchmark index that we all know and love. But even this index has its shortcomings. For while it captures most of the market by tracking what are 500 of the largest stocks in the U.S. markets, it does overlook the fact that there are another 4,418 publicly traded exchange traded stocks in the U.S. that investors may also find upside opportunity at any given point in time.

For the purpose of this discussion, it is worthwhile to consider instead the Russell 3000 Index (NYSEARCA:IWV), which effectively tracks the performance of the 3,000 largest stocks in the U.S. And when examining the Russell 3000 versus the S&P 500, we see that the returns performance has been almost perfectly correlated since the outbreak of the financial crisis nearly a decade ago.

Relative Performance And Regression To The Mean

So what exactly are we searching for in this exercise relative to the Russell 3000 Index? Recognizing that so many stocks are expensive on an absolute valuation basis to varying degrees in the current market environment -- indeed the market has individual names like Gilead Sciences (NASDAQ:GILD) and General Motors (NYSE:GM) that appear notably inexpensive on a historical price-to-earnings ratio basis, but these are the exceptions and not the norm -- we are searching for segments of the U.S. stock market that have been relative laggards and may be well positioned to regress back to the broader market mean at some point in the future.

What exactly do we mean by regression to the mean? The U.S. stock market follows a certain path over time. And as it travels along this path, certain segments of the market will lead the overall market, while others will fall behind. But over longer term periods of time, those segments that lead the market eventually fall back down to the market, while those that are behind eventually catch back up. As a result, if you are positioning on the long side for a stock, sector or segment to regress back to the mean, it means that it is a segment that has fallen behind the broader market and is overdue to begin catching back up. The appeal here is that the strategy should provide greater upside potential since if it needs to catch up to a rising market as well as greater downside protection since it has already absorbed some of the downside in a falling market.

So where are we seeing deviations from the market mean today? During the post crisis period, we have seen growth stocks consistently lead while value stocks have lagged. Given that growth and value have generated comparable returns over the long-term despite extended periods of leadership by one side or another, it is reasonable to expect that growth will eventually regress its way down to the broader market, while value will eventually regress its way back higher to catch up. Thus, value is currently presenting an attractive opportunity from a relative performance and regression to the mean standpoint.

But exactly where in value do the opportunities reside? For this, we can dissect the value area of the market into its various size components. This includes large value (NYSEARCA:IVE) stocks within the S&P 500 Index, the mid-cap value stocks (NYSEARCA:IJJ) within the S&P Mid-Cap 400 Index (NYSEARCA:IJH), the small-cap value stocks (NYSEARCA:IJS) within the S&P Small-Cap 600 Index (NYSEARCA:IJR), and a more expansive list of small-cap value stocks (NYSEARCA:IWN) within the broader Russell 2000 Index (NYSEARCA:IWM).

What we find here is the following. Relative performance laggards are not likely to be abundant among the value offerings found in "middle 900" of the U.S. stock market. For both the S&P Mid-Cap 400 Index and S&P Small-Cap 600 Indices have performed effectively in line with the broader market since the outbreak of the financial crisis back in 2007.

Instead, one notable segment of relative underperformance has been among large cap value stocks, as the S&P 500 Value Index has lagged the broader market since the outbreak of the financial crisis. The primary driver of this underperformance has been the financial sector (NYSEARCA:XLF), which much like the technology sector in the years following the bursting of the tech bubble has struggled to regain its mojo in any meaningful way. Of course, the fact that interest rates have been pinned at zero percent for so many years has made things challenging from a net interest margin perspective as well. It should be noted that not all banks have struggled in the same way, as stocks like Wells Fargo (NYSE:WFC) and JP Morgan Chase (NYSE:JPM) have tracked the market while others like Bank of America (NYSE:BAC) have fallen far behind. But for those seeking a regression to the mean opportunity either from a broad allocation or individual stock perspective, the large value space may be a worthwhile place to explore.

Perhaps an even better place for investigation in today's market is the small cap value segment as measured by the Russell 2000 Value Index. Unlike its S&P Small-Cap 600 Value counterpart, the IWN has fallen notably off the pace since the start of 2014.

What explains this trailing performance of what effectively represents the "lower 1500" of the small cap value universe? The answer once again lies primarily in the financials, for the regional banks (NYSEARCA:KRE) has fallen on relatively slim times over the last couple of years. Whereas financials only make up 22% of the IJS, they make up nearly double of the IWN at 41%.

But this is not the only explanation. For the entire microcap segment (NYSEARCA:IWC) of the U.S. stock market, which includes the 1,000 smallest stocks in the Russell 2000 Index plus the next 1,000 stocks beyond that index (think of it as the 2,001st to 4,000th largest stocks in the U.S. stock market), has also fallen off the broader market pace over the past couple of years.

The fact that these two segments are underperforming are notable and may imply opportunity for the regression to the mean seeking investor.

First, small cap value stocks have historically performed well during periods of sustained stock weakness such as prolonged bear markets. In fact, investors that were concentrated in small cap value stocks enjoyed a roaring bull market throughout the bursting of the technology bubble and beyond at the turn of the millennium. Taking the flip side from a more bullish economic perspective, if the Federal Reserve is ever able to normalize interest rates, the regional banks that make up a big part of this area of the market stand to benefit most thanks to a long-awaited improvement in net interest margins that would likely accompany such a shift.

Second, microcap stocks rank among those that have historically performed among the best amid an improving economy, even more so than U.S. small caps. Thus, if you are of the opinion that we are soon finally entering a period of more sustained economic growth, then microcap stocks may be worth a look from a regression to the mean perspective. Moreover, microcap stocks along with their small cap counterparts also have a demonstrated track record of performing well during rising interest rate environments thanks to their relatively low levels of debt versus their mid and large cap counterparts.

Bottom Line

The overall market may be expensive, but that does not mean that it is not without its selected opportunities. And for those investors who are more optimistic about the U.S. economy and the ability of the U.S. Federal Reserve to raise interest rates, the large cap value, small cap value and microcap segments of the U.S. stock market are offering the best opportunities from a relative performance and regression to the mean perspective. Included among these are financials including some of the major money center banks as well as their smaller regional bank counterparts.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long GILD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long selected regional banks.