As fundamental investors, the Pax Small/Mid Cap team is primarily focused on individual security analysis to identify high quality companies at reasonable valuations for inclusion in the Pax Small Cap Fund (PXSIX) and Pax Mid Cap Fund (PMIDX).
However, we also feel it’s helpful to have a view of where markets are from a valuation and investor sentiment standpoint. In this article, we’ll take a look back at why recent market returns have been so strong and then discuss market expectations for 2018.
The economy is about to enter the ninth year of this expansion, unemployment appears poised to drop below 4% and equity markets across the globe continue to march higher.
As 2017 concludes and investors turn their attention to the year ahead, the question remains — can this bull market continue? For now, most investors appear to be betting that it will, despite valuations that are meaningfully higher than average. Small cap stocks, as measured by the Russell 2000 Indexx, trade at 25 times next year’s expected earnings. This is approximately 35% above the trailing ten-year average and valuations haven’t been this high since the technology bubble of the late 1990’s.
Figure 1: Russell 2000 Index Forward P/E Next 12 Months Consensus Earnings – 11/21/2007 to 11/21/2017
Forward Price-Earnings Ratio is a ratio for valuing a company that measures its current share price relative to its per-share earnings over the next 12 months.
How did we get to this point? Following the Great Recession of 2008, the Federal Reserve (Fed) and central banks around the world embarked on an extraordinary policy of quantitative easing (QE). One of the goals was to push investors to take more risk by suppressing interest rates. Bond buying made fixed income yields so unattractive that the Fed seemingly forced investors to purchase equities to earn a reasonable return.
The Fed reasoned that rising equity markets would not only allow financial companies to recapitalize, but would create a wealth effect that would boost the economy. The policy was quite effective with respect to equity returns and after a slow start, the economy finally looks to be hitting its stride.
In our view, one of the keys to 2018 will be the level of inflation expectations. In October, nine years after Ben Bernanke started this “emergency policy,” as he called it, the Fed began the slow process of reducing the size of its balance sheet. Some have called this quantitative tightening (QT). This followed the late-2015 start of raising the Fed Funds rate off the zero-bound.
If inflation remains low, investors will expect a gradual increase in Fed Funds and a similar pace of balance sheet reduction. If inflation appears to be increasing and/or the Fed becomes concerned with investor complacency, the pace could quicken. Figure 2 below shows market expectations of inflation over the next ten years.
While inflation expectations remain anchored, the combination of increasing commodity costs and nascent wage inflation could point to additional firming. If QE boosted asset prices, might QT pressure them?
Figure 2: U.S. Breakeven Inflation Expectations – 11/21/2012 to 11/21/2017
We believe one of the key contributors to the absolute level of valuations and lack of volatility is the massive flow of funds into passive and quantitative strategies. As illustrated in Figure 3 below, more than $2 trillion has moved to passive and $621 billion from active over the last 10 years.
Passive strategies tend to be mechanical in nature, deploying new money to replicate an index by indiscriminately investing in all stocks – and allocating the most capital the largest and often highest valued names. As a result of persistent inflows to passive, momentum begets momentum and expensive stocks that have grown larger in the index tend to stay expensive. In small cap, passive now accounts for between 40%-50% of assets. This market share is up meaningfully and potentially impacting the price discovery function that active management contributes to the overall market.
Figure 3: Cumulative flows to active vs. passive equity funds (1/1/2007 to 10/31/2017)
Source: Morningstar Direct.
Our expectation is for muted small cap returns in 2018. In short, we believe that valuations near multi-decade highs will limit meaningful gains from current levels.
While we agree with bullish investors that the economy is strong and tax reform could serve as additional fuel, we disagree on the extent to which economic growth is priced-in. The absolute level of valuation and lack of volatility suggests investors are quite positive. In our experience, when the pendulum swings too far in one direction, it makes sense to position for the inevitable change in course. We remain defensively positioned, favoring sectors and companies where our estimate of downside risk is lowest.
Our investment approach is designed to drive performance primarily from stock selection. In today’s highly priced and increasingly risky market, we believe maintaining a focus on quality, risk management and valuations is especially important.
xThe Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. One cannot invest directly in an index.
Equity investments are subject to market fluctuations, the fund’s share price can fall because of weakness in the broad market, a particular industry, or specific holdings. Funds that emphasize investments in smaller companies generally will experience greater price volatility.