2021 First Quarter Market Update- Small Caps and Big Comebacks
Spring is in the air. Cheers to brighter skies, warmer weather, and reconnecting!
For a long time, many of our portfolios have had a slight bias towards small cap stocks (stocks with a total market value under two billion dollars). Sometimes this bias helps performance and sometimes it hurts. We believe that over the long term, in exchange for a small amount of additional risk, small cap stocks will provide better returns than their large cap counterparts.
Our data based belief has proven true over time (at least over the last 20 years). In the chart below, large caps are represented by the S&P 500 (Green) and small caps are represented by the Russell 2000 (Red).
As you can see, over the last 20 years, small caps have outperformed. This is despite going through three recessions during that time period (highlighted in grey).
We also recognize that correctly predicting when small caps will outperform large caps is extremely improbable. Additionally, we have to recognize that due to the additional risk of small cap stocks, they can be especially vulnerable during market crashes.
Case in point Q1 of last year.
It should shock no one that small caps were hit the hardest in the beginning of the Covid Crash. By the end of the first quarter, they were down over 30%, however, that was not the low point. The maximum loss for the Russell 2000 was on March 23rd when it was down over 40% from its high!
But what comes down often comes ROARING back and that is exactly what small cap stocks have done. (124.3%!) That is what the Russell has done since it's low on March 23rd of 2020.
This has no doubt been an incredible rally in small cap stocks. This series of events definitively show the need for investors to have a plan and to rely on logic, not emotions, to drive decisions. We are proud to have maintained our conviction through the challenging past 12 months, but we are even more proud to have so many clients believe in us, our approach to investing, and to have stuck it out without panicking. So, on behalf of all the FSG team, thank you!!
That brings us to more recent market movements and outlooks. Recently small caps have been maintaining their strength, while international stocks and bonds have struggled.
The weakness in bonds is a result of rising interest rates. The rise in interest rates and inflation seem to be the two items on everyone's mind. I want to address the rise in interest rates here, today. When it comes to inflation, that is a longer topic, one that we will do another market update about soon. Keep an eye out for it!
Most people believe that the Federal Reserve sets interest rates. This is only partially true; they set the fed funds rate which is the interest rate at which banks lend to each other. The more important interest rates for investors are the rates on U.S. treasuries. These rates are set by supply and demand. Basically, if investors are scared and fleeing the stock market or other risky investments, they often buy U.S. treasuries. If there is a lot of demand, interest rates will go down, but if there is little demand (because everything seems peachy) then interest rates on treasuries rise.
As the economy reopens and the world begins to spin again people are optimistic about the economy and the market. This means in the current environment, demand is relatively low for treasuries and therefore, rates have risen. Rising interest rates put pressure on bonds. As long as there is market optimism and little headwinds, rates will likely continue to rise (albeit slowly). This means that bonds are likely to face more pressure. However, we cannot simply bail on bonds as a result of this expected pressure for a variety of reasons: 1. Bailing on an asset class is just not part of our investment philosophy. That is market timing, and as we have said many times, market timing is a fool's errand. 2. Bonds provide an important hedge against stock market volatility and although things are good right now, we know that will not always be the case.
Thank you for reading. As always, if you have any questions or concerns, please feel free to reach out to your FSG team. Have a blessed spring!
This commentary on this website reflects the personal opinions, viewpoints and analyses of the Financial Strategies Group, Inc employees providing such comments, and should not be regarded as a description of advisory services provided by Financial Strategies Group, Inc or performance returns of any Financial Strategies Group, Inc Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Financial Strategies Group, Inc manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
Written by: Brice Carter