The rate cut by the Federal Reserve in late October was a shot in the arm for investors concerned about recent lackluster industrial economic data. The move was viewed as a needed backstop to prevent a temporary lull from turning into a prolonged downturn.
As investors grew more confident that current weakness might be short-lived, they bid the major indices to a string of new highs in late December. The upbeat tone on Wall Street was a boon for lower quality businesses.
After spending much of the previous quarter under scrutiny, many debt-laden companies were bid up as investors concluded balance sheet strength was a concern for another day. This approach is short-sighted, in our view, given the unprecedented levels of corporate debt—estimated at more than $3 trillion—that will need to be refinanced in the next few years.
The march higher took on a familiar feel as larger names continued to outpace smaller. The pull of large companies has become so strong that, as shown [below] [to the right], the 10 largest companies in the S&P 500 have a combined market cap of MORE THAN 3X THE ENTIRE RUSSELL 2000® INDEX of small companies. This type of stampede into pricey mega-caps has historically ended poorly for those who followed the crowd.
No room for error?
Despite mixed economic data and extreme corporate debt levels, we would not be surprised to see the markets surge higher in the near-term as investors who were sitting on the sidelines jump back into equities out of fear of missing out on the next big rally. Yet we believe the recent runup in valuations has reduced the margin for error in today’s markets.
A slow and steady trajectory for the economy could amplify the differences between high-quality businesses with a clear, achievable path to improvement from those that have binged on debt in an attempt to evade a future day of reckoning. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.
Disclosure
Past performance does not guarantee future results.
Investing involves risk, including the potential loss of principal. There is no guarantee that any particular investment strategy will be successful. Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.
The statements and opinions expressed in this article are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter’s views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change.
Small-cap and large-cap investment strategies each have their own unique risks and potential for rewards and may not be suitable for all investors. Small-cap investment strategies emphasize the significant growth potential of small companies, however, small-cap securities, are generally more volatile and less liquid than those of larger companies. Large-cap investment strategies emphasize the stability of large companies, however, large-cap securities are more susceptible to momentum investments and may quickly become overpriced or suffer losses.
Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.
Definitions:
Russell 2000® Index includes the 2000 firms from the Russell 3000® Index with the smallest market capitalizations. S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index.
Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indices. Russell® is a trademark of the Russell Investment Group.
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