Thought for the Week (300):
The Three Types of Lies
Synopsis
· Small-cap stocks are often viewed as a barometer for investors’ risk appetites, and these equities have corrected sharply over the past two months.
· Of the prior thirty-five corrections since 2000, each was accompanied by a subsequent move in large-cap stocks. However, this most recent correction has failed to impact the S&P 500.
· The Investment Committee believes that large-cap stocks have not corrected because valuations in the S&P 500 are lower and economic data continues to be positive.
The Three Types of Lies
Mark Twain popularized the following saying in “Chapters from My Autobiography”, published in the North American Review in 1906:
“There are three kinds of lies: lies, damned lies, and statistics”
Pushing the satire aside for a moment, this famous quote is a constant reminder to investors that although statistics are powerful tools to help us recognize relationships, it’s far more important to isolate and analyze the drivers of a relationship in order to profit in the future.
Investors often succumb to the dangers hidden within statistics simply because they carry very powerful psychological triggers. It’s human nature to want to believe statistics on face value, and often the work required to support or disprove a relationship is either daunting or deemed irrelevant given the observed strength in the relationship.
NOTE: Think about how many statistics are quoted during nightly news broadcasts on TV. Then think about how few of these figures are broken down to the point where they explain how the data was gathered and/or analyzed.
Furthermore, what may appear to be a relationship is often nothing more than coincidence. For example, visit the website, http://www.tylervigen.com/, to learn that the correlation between the per capita consumption of margarine in the U.S. and the divorce rate in Maine is incredibly high.
Simply put, the danger for investors is that “spurious correlations”, or false correlations, are pervasive in markets, and we must do more than just observe a relationship in order to prevent losses and maintain low risk levels.
Small Cap Stocks Are Correcting
There has been an extraordinary amount of chatter recently about the Russell 2000, which is an equity index that represents small-cap stocks totaling close to 10% of the total U.S. market capitalization.
Although this index may appear to be insignificant versus the larger S&P 500, investors use the Russell 2000 as a barometer for investors’ risk appetites because these investments typically offer shareholders a higher growth rate than larger companies. For example, a small tech startup can achieve annual growth rates well above 100%, whereas Apple would be difficult to see mid-teens growth rates given they already generate around $180 billion in revenue in a year.
When bulls are rampant in the market, the Russell 2000 seems to lead the charge. In fact, of the eight years since 2000 when equities ended positive, small-cap stocks averaged annual returns of around 23%. This figure is materially higher than the 16.4% return of the S&P 500 during the same time period.
The Russell 2000 had a fantastic 2013, delivering its best year since the tech boom in 2000 with returns of 36.8%. However, investors have been forced to endure a decline of almost 5% so far in 2014, and these stocks are down over 10% since their last peak, which had not happened since November 2012.
Wall Street tends to label a move greater than 10% down as a “correction”. This most recent correction in small-cap stocks is the 36th one since 2000, and the average decline during these periods is around 17%.
What is most interesting here is that of the first 35 corrections, each one was accompanied by large-caps also falling around 13%, until now. Simply put, this seemingly obvious relationship predicated upon historical performance appears to have broken down (the S&P 500 is actually positive year-to-date).
The investors that merely observed this supposed relationship and then acted accordingly are currently scratching their heads. The Investment Committee, on the other hand, has done the work to deduct the real reason why small-cap stocks are correcting and large-caps are not.
Valuation Now Matters
We believe that small-cap stocks have corrected so sharply this year because the market has started to pay attention to valuation. Small-cap stocks flew too high too fast, and investors became nervous holding many stocks that trade at meteoric valuations with little to no earnings.
Large-cap stocks, on the other hand, are nowhere near as expensive. On a historic basis, the S&P 500 is trading in a range that the Investment Committee considers to be fairly valued. Simply put, large-caps are neither cheap nor expensive, and we therefore continue to be opportunistic and wait for cheap stocks to emerge that can offer attractive returns for our investors.
The bottom line is that the Investment Committee keeps a very close eye on valuation because we invest for the long term. Stocks that carry high valuations must prove that their future expected growth is real or else they will fiercely correct. Hence, we manage our downside by looking for quality/misunderstood stocks with valuations that are so low that it creates an implicit floor in the stock price.
Lastly, although statistics are certainly worth observing, investors should never take them on face value. Large-cap stocks don’t simply follow small-cap stocks blindly, and the year-to-date performance of the Russell 2000 and S&P 500 support this conclusion. Large-cap stocks continue to show strength because their valuations are lower and the economic data continue to point to a slowly growing economy.
