In terms of markets, the first two months of 2019 look much different from the last two months of 2018…so far. In November and December of 2018, markets in most of the world were taking two steps down for every step up – and often large, erratic steps.
Conversely, in January and February of 2019, markets have (once again) been rising benignly. Put another way,
CNN’s Fear & Greed Index has swung all the way from (red) “extreme fear” back solidly into (green) “greed”.
Were the last two months of 2018 nothing but a bad dream? Were markets, perhaps, just experiencing some passing “indigestion”, after digesting years of mostly rising valuations?
For investors who subscribe to this viewpoint, current valuations look extremely attractive – especially for small-cap stocks. Small-cap valuations across most sectors were
already compressed as we entered November 2018. Further declines merely rubbed salt in the wounds of investors.
Optimistic small-cap investors, therefore, should be preparing to “load the boat”. But is this a realistic viewpoint after (especially in the U.S.) an inordinately long run of rising markets? For some investors, the end of 2018 wasn’t/isn’t a bad dream. Rather, it’s the first two months of 2019 that are a mirage.
Market pessimists have other factors to concern them apart from the extended uptrend in markets. Interest rates have been rising (very) slowly, and even after ten years of so-called “tightening” Western central banks still haven’t brought rates back to historically normal levels.
Officially, it’s been many years since the last economic contraction. On the other hand, less-myopic readers may be straining their eyes trying to see signs of “economic growth”, as the streets of major urban centers continue to team with Homeless People. If
this is prosperity, we certainly don’t want to see any real economic hardship.
The signals today, then, are certainly mixed. With the question about short-term valuations up in the air, shrewder investors may see now as the time to take more notice of long-term fundamentals. Unlike the statistically unreliable “noise” of short-term data, longer term data and fundamentals inevitably provide a clearer picture.
And the “picture” from the long-term perspective is that small-cap public companies have never been more attractively priced versus large-cap stocks. Never.
Part of this valuation disconnect is due to the irrational run-up in large-cap valuations. These valuations are still at extremely excessive levels particularly in the U.S. But part of this disconnect even predates the current uptrend in stocks.
Small-cap valuations have been lagging large-cap valuations by increasing margins for well over a decade. Over the long term, this isn’t sustainable. It will
always be easier for a $1 million market cap company to become a $2 million company than for a $1 billion company to become a $2 billion company.
This epic disconnect between large-cap and small-cap valuations means that investors with a longer investment horizon don’t need to be as fearful about investing in small-caps currently as they might be otherwise. If the upturn in markets to start 2018 doesn’t last, investors are in a much stronger position over the long term by being heavier into small-caps.
The alternative? Warren Buffett, the Oracle of Omaha has been (increasingly) sitting on the sidelines since 2015. With currently 40% cash, Buffett is holding roughly $120 billion for Berkshire Hathaway shareholders that is doing
nothing.
This would be extremely unproductive at the best of times for a long term “value investor” like Buffett. In our current high-inflation environment, such a strategy borders on suicide.
While Western central banks continue to peddle their “low inflation” mythology, investors who live in the real world know better. With food and housing costs spiraling higher at the fastest rate in history, inflation is anything but “low”.
The mountain of paper that Warren Buffett is currently sitting on is being gobbled up by this inflation, every minute of every day. At some point, Berkshire Hathaway shareholders will begin asking themselves whether Old-Man Buffett is being “cautious”, or merely indecisive – as their billions are being devoured.
Small-cap investors with a long time horizon (and strong risk tolerance) don’t need to form a strong opinion on current market conditions – and then go to bed each night worrying if they have bet wrong. While valuations for small-caps could always go lower should markets again turn down, they don’t have nearly as far to fall as bloated large caps.
As an exclusive large-cap investor, Warren Buffett is currently too timid to do more than dip his toe in the water. Valuations look much less intimidating for the small-caps.
For traders pondering
betting on stocks, there is no clear guidance at the present time. However, for investors thinking about
investing in companies, the picture is much clearer.