Who Would've Thunk It?

My hats off to anyone brave enough to offer predictions. Forecasting financial markets makes astrology look like real science.

I have tried to imagine the reaction I would have received if I told someone at the beginning of November that:

  1. the Biden ticket will be elected but contested
  2. COVID-19 infections will reach record levels
  3. the Dow Jones Industrial Average will have its best month since 1987
  4. Small capitalization stocks would have their best month ever.
  5. A blank stare would probably be the kindest response I would have gotten.

But that is what happened.

It goes to show, once again, that thinking we have any idea as to what is around the corner is best left to the fortune teller in the little booth at the county fair.  

While not making predictions, in the investment world, we often find (without any certainty as to the timing), that areas of the investment market that have been in the penthouse often get shoved to the basement, while areas that have been out of favor move up to the penthouse.

The chart below shows the November performance of two S&P indexes. The S&P 600 (purple line), which is their small cap stock index and the S&P 500, which is their large cap stock index. While the largest stocks had a great month, the smallest almost doubled their big brother’s performance.

S&P 500 and 600 Changes

We don’t know how long this outperformance of small stocks versus large stocks will last, however it comes after a long period of small stocks underperforming their bigger brethren. Looking back over the last 20 years, this small cap outperformance also occurred after the tech bubble of the mid-late 90’s. Small cap stocks subsequently outperformed large cap growth stocks for 7 years (2000-2006).

Below is a periodic table that shows how various sectors of the investment market have performed over the last 20 years. You can see the poor performance of large growth stocks from 2000-2007 (following the tech bubble) and excellent performance of the same for 4 of the last 5 years. (Large cap growth sector is circled in red below).

Variability of Investment Returns

This is why “driving with the rear view mirror” is often detrimental to an investor’s financial health. Historically, investors tend to invest where the performance has been good- emphasis on the “has been good.” Normally, what “has been good” means their share prices have gone up a lot, which can imply they have become expensive, therefore diminishing their expected future returns.

The hard part of investing is taking money out of what has done well and putting those proceeds in segments of the market that have been acting poorly. But taking some money out of an investment sector which, due to its good performance has become expensive, and adding to areas that have underperformed and therefore become inexpensive, is a discipline which can improve an investors’ probability of success.

Once again, many counterintuitive results occur in the financial markets. The stock market is certainly disconnected to what main street business is currently experiencing, but the market is a discounting mechanism of future expectations.

What are some of those expectations? There are now several very effective vaccines that are expected to be widely distributed by the first half of 2021. There are also new hopes for a stimulus package to tide struggling citizens and businesses to a time when the vaccines are widely distributed.

Still supporting the stock market is that the return provided by bonds and “safe money” alternatives are too low for investors who require a significantly higher rate of return to reach their goals. Bonds still have a place in many investors’ portfolios, but as a preservation of wealth asset not as a high return sector.

So being diversified, not just between stocks, bonds and cash, but also in different segments of the stock market, provides you more opportunities to your portfolio do well.

As this is our last newsletter of 2020, we want to thank you for allowing us to work with you through some of the most volatile markets in history. I believe more so than any other year of my 37 year career, Warren Buffet’s quote stating that “The most important quality for an investor is temperament, not intellect.” has proven to be true.

As always, don’t hesitate to call with any thoughts, questions or anything new in your life and goals that we need to discuss. And as always, thank you for the trust and confidence you have placed in us.

Beach

Disclosure:  This market commentary is provided for information purposes only and is not a complete description of the securities, markets, or developments referred to in this material. Any opinions are those of the author and not necessarily those of Raymond James. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.  The S&P 600 Small Cap Index covers a broad range of small cap stocks in the United States. The index is weighted according to market capitalization and covers about 3-4% of the total market for equities in the United States. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Diversification and asset allocation do not ensure a profit or protect against a loss.