Patiently Waiting for Mean Reversion by Frank Holmes

So far this year, small-cap growth stocks have surprisingly been lackluster. After 2013, when it gained a scorching 38.8 percent, the Russell 2000 has delivered a tepid 0.62 percent year-to-date (YTD).

Mean Reversion
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Performance has been so poor, in fact, that the spread, or bifurcation, between the 12-month return residuals of small and large caps is at its widest since the dotcom bubble of the late 1990s and early 2000s. This bifurcation is one of the largest since 1975.

According to Morgan Stanley, we’re in the worst beta-adjusted period for small-cap stocks since the late 1990s. The 12-month return in August for small-caps was -9.7 percent, placing it in the bottom 6 percent of any 12-month period since the mid-1970s.

Mean Reversion
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The bifurcation is more than apparent when you compare the year-to-date (YTD) total returns of the big boys (those in the S&P 500 Index and Dow Jones Industrial Average) to their little brothers (those in the Russell 2000 and S&P SmallCap 600 Index). The Russell, though it led the other indices in March, has failed to reach a new record high, which the S&P 500 and Dow managed to achieve in the last couple of months.

Mean Reversion
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Are We on the Verge of Another Bubble?

We don’t think so. History shows bubbles are associated with excessive leverage and lofty valuations. That is not the case this time.

In July, Federal Reserve Chairwoman Janet Yellen stated in her semiannual report to Congress that small caps appear to be “substantially stretched,” even after a drop in equity prices at the beginning of the year.

There may be some truth to Yellen’s remark, an ideological echo of former Fed Chairman Alan Greenspan’s now-famous “irrational exuberance,” his description of investors’ rosy attitude toward dotcom startups of the late 1990s and early 2000s.

Much of the valuation gap has evaporated. Looking at the price/earnings to growth ratio—20x for the Russell 2000 and 18x for the S&P 500—small caps have slightly higher yet reasonable multiples and may offer better long-term growth prospects.

Mean Reversion to the Rescue

The recent underperformance among small caps has been a headwind for a few of our funds, most notably our U.S. Global Investors Holmes MacroTrends (MUTF:MEGAX), whose benchmark, the S&P 1500 Composite, tracks the performance of not just large- and mid-cap U.S. companies, but small-cap as well. With a bias toward small-cap companies, the fund has underperformed compared to last year, when such stocks were doing well.

Because small caps tend to have higher beta than blue chips, you would expect them to outperform in a generally rising market—which we’re currently in. So it appears that a major rotation out of these riskier, more volatile stocks has inexplicably occurred, leading to the wide bifurcation between small and large companies.

The good news is that, based on 20 years of historical data, stocks in the Russell 2000 tend to rally in the fourth quarter and continue steadily until around the end of the first quarter. Over this 20-year period ending in December 2013, the Russell has generated an impressive annualized return of approximately 10 percent.

Mean Reversion
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Whether or not this fourth-through-first-quarter rally will recur in 2014 and early 2015 is impossible to forecast. What can be said, however, is that prices and returns do tend to revert back to their mean over time.

I discussed this concept in full last month in the second part of my “Managing Expectations” series, “The Importance of Oscillators, Standard Deviation and Mean Reversion.” Although small caps are underperforming right now, the concept of mean reversion suggests that they’ll return to their historical relationship with large caps eventually—just as they did following the dotcom bubble.

In his 2006 book The New Rules for Investing Now: Smart Portfolios for the Next Fifteen Years, investor James P. O’Shaughnessy makes the case that small stocks have a performance advantage over large stocks simply because, well, they’re small. This might sound like circular logic, but as he writes:

A company with $200 million in revenues is far more likely to be able to double those revenues than a company with $200 billion in revenues. With large companies, each increase in revenues becomes a smaller and smaller percentage of overall revenues. Small stocks, on the other hand, have a much easier time delivering great percentage growth in revenues and earnings.

O’Shaughnessy examined every 20-year rolling time period beginning each month between June 1947 and December 2004. That’s 691 20-year rolling time periods. What he found is that “small stocks outperformed the S&P 500 84 percent of the time.”

Mean Reversion
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If O’Shaughnessy’s research is accurate, it seems very reasonable to be optimistic in the long term. It would be myopic to look only at the Russell 2000’s recent underperformance and impulsively rotate out of small caps without also considering the decades’ worth of data showing the growth that can be achieved.

Why It’s Important to Have Your Funds Actively Managed

Comparing index funds to actively managed funds, Kiplinger columnist Steven Goldberg wrote last month: “[I]ndex funds are designed to give you all the upside of bull markets and every bit of the downside of bear markets. Only good actively managed funds can protect you from some of the pain of a bear market.”

We at U.S. Global Investors agree with Goldberg’s attitude toward good active management. Although MEGAX might be temporarily underperforming right now as a result of the sentiment-driven and disappointing performance of small-cap stocks, we’re confident that they will eventually revert back to their historical pattern as fear over Fed tightening settles down and fundamentals prevail.

In the meantime, we will continue to apply our dynamic management strategy of picking stocks in the fund using the 10-20-20 model: we focus on companies that are growing revenues at 10 percent and generating a 20 percent growth rate and 20 percent return-on-equity. This approach has served us very well in the past and enabled us to select the most attractive growth-oriented companies for our clients.

A Note on the Strong U.S. Dollar and Gold

As I explained in a recent Frank Talk, a strong U.S. dollar could spell trouble for commodities such as gold, which tend to have a historic inverse relationship to the dollar.

Mean Reversion
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When the dollar does well, investors often choose to store their money in paper rather than bars. Though September is statistically the best month for gold, with the dollar rising almost two standard deviations above its mean, this month might not be kind to the yellow metal and other commodities. In the Gold Market section below you can see how gold is faring far better in euro terms.

Index Summary

  • Major market indices finished higher this week.  The Dow Jones Industrial Average fell 0.87 percent. The S&P 500 Stock Index dropped 1.10 percent, while the Nasdaq Composite declined 0.33 percent. The Russell 2000 small capitalization index fell 0.81 percent this week.
  • The Hang Seng Composite fell 2.23 percent; Taiwan declined 1.96 percent and the KOSPI dropped 0.37 percent.
  • The 10-year Treasury bond yield rose 15 basis points to 2.61 percent.

Domestic Equity Market

The S&P 500 Index pulled back from recent highs this week as investors speculate that the Federal Reserve is moving closer to raising interest rates and could telegraph that message to the market at next week’s Federal Open Market Committee (FOMC) meeting.

Mean Reversion
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Strengths

  • The technology sector outperformed this week with nearly breakeven performance on the back of Apple’s roll out of the new iPhone 6, watch and electronic-payments service. Yahoo! was the best performer in the S&P 500 as the highly anticipated Alibaba Group initial public offering (IPO) is well received by the market and is expected to price next week. Yahoo! owns roughly 22.5 percent of Alibaba Group.
  • The financial sector also outperformed as investment banks and brokerage-related names such as E*Trade Financial, Bank of America, Charles Schwab and Goldman Sachs were up. Regional banks showed strength this week as higher, short-term interest rates were positive for the group.
  • Technology and financials dominated the best-performers list in the S&P 500 this week. Other areas with good performance included health care facilities, airlines and computer and electronic retailers.

Weaknesses

  • The energy sector was hit hard again this week in another broad-based sell off. The only difference between this week and last week was that refiners were not spared. Talk of allowing U.S. oil producers to export oil pulled refiners lower this week. Refiners benefit from the relatively cheap price of domestically produced oil versus the international market price. These two prices could converge if oil exports were allowed, hurting refiners’ margins.
  • The utility sector was also a laggard this week as treasury yields moved higher on fears that the Fed is moving closer to raising interest rates.
  • Discovery Communications was the worst performer in the S&P 500 this week, falling by 8.98 percent. Ratings for Discovery’s networks were lower in July and August, which could hurt future ad revenue.

Opportunities

  • Bank of Japan governor Kuroda stated that the central bank will take any steps needed to meet its 2 percent inflation target. This comes on the heels of last week’s surprise interest rate cut from the European Central Bank (ECB). This is good for risky assets and global equities in particular.
  • The U.S. economy is currently a bright spot in the developed world, potentially allowing money to funnel back into the U.S. equity market.
  • The path of least resistance for the market appears higher as this “classic” bull market phase of grinding higher with lower volatility remains intact for now.

Threats

  • Volatility has been remarkably low and this bull market has been an abnormally smooth ride. This calmness won’t last forever and late summer early fall has traditionally been more volatile.
  • The big identifiable threat next week is Wednesday’s FOMC meeting, with the Fed potentially shifting to more hawkish language and signaling to the market that higher interest rates are coming, potentially within the next six
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