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Stone's Weekly Market Guide - Week of September 28, 2020

Chart of the Week: Shakespeare wrote about Hermia “though she be but little, she is fierce”, but he could just as easily be referring to small-cap stocks now. Until the poor showing this week, small market capitalization stocks, defined as the Russell 2000, had been outperforming the S&P 500 since the March low but still lagged well behind year-to-date. This underperformance coincided with a recent piece from AQR looking at the long-term performance of small-cap stocks. Summarizing and simplifying the findings: small-cap stocks have outperformed large-caps on an absolute basis since 1963 but after adjusting for risk (volatility) and market exposure (market beta) this outperformance disappears. Most investors implement small-cap index allocations using the Russell 2000 (RTY) or the S&P 600 (SML). Generally, the RTY is simply the smallest 2000 companies within the Russell 3000 index and currently contains many companies without positive earnings. The SML is a smallest capitalization subset of the S&P 1500 with the constituents at the discretion of their Index Committee. Among the S&P’s eligibility requirements are that the company should have been profitable over the past year and most recent quarter. More details about their respective index methodologies are here and here. Our chart illustrates: small-caps have significant periods of underperformance; price volatility is generally higher for small-caps; and small-caps are subject to higher earnings variability as illustrated with the plunge in the wake of the coronavirus. When using the SML to remove the distortion from the non-earners, small-cap stocks do not look expensive relative to large-caps but are generally lower quality companies than large-caps. Small-cap stocks also provide exposure to additional earnings leverage and long-term outperformance, so a continued allocation to small-cap stocks is likely warranted within an asset allocation for investors willing to tolerate the additional volatility.


Chart 1: Long-term Small-Cap Performance and Valuation

Chart 2: Small-Cap and S&P 500 Performance from the 2020 Low

Week in Preview


· Geopolitical: With lockdown measures being re-introduced in parts of the globe to combat a resurgence in COVID-19 infections, the impact on economic activity will be closely monitored. Tensions between the U.S. and China will be watched for further escalation. President Trump nominated Amy Coney Barrett to replace Ruth Bader Ginsberg on the Supreme Court with the Democrats certain to go all out to block her confirmation. The first U.S. presidential debate will be held in Cleveland on Tuesday.


· U.S.: 3Q ends on Wednesday and markets may see higher volatility as managers adjust positions. A remarkably busy calendar lies ahead with August personal income and spending along with September auto sales and ISM Manufacturing on tap. The main event will be the September jobs report, since it is the last monthly reading on the labor market before the presidential election. The pace of improvement is expected to slow, but nonfarm payrolls are estimated to increase by 850,000 and the unemployment rate to decline to 8.2%. If last week was not enough, there is another sizable slate of Fedspeak scheduled again this week. Readings for our U.S. Reopening Monitor declined last week primarily due to market indicators but initial readings on new COVID-19 cases and deaths fell on a week-over-week (W/W) basis. Improvement continues in the underlying high frequency economic data for consumer sentiment, retail sales and dining but the gains are slowing. The reopening and economic data are now similarly grinding higher after the sharp rebound for most of 3Q. While 3Q GDP growth is likely to be around 30%, 4Q should slow to a single digit rate as the easier part of the rebound is now likely behind us. The Atlanta and New York Fed’s estimate of 3Q GDP growth are 32.0% and 14.1%, respectively. Please see our U.S. Reopening Monitor and our Guide to the U.S. Reopening Monitor for more details.



· S&P 500 Earnings: Just five S&P 500 companies are reporting earnings with Micron Technology (MU) and PepsiCo (PEP) among the more interesting reports. As we forecasted, 2Q earnings showed large earnings declines but handily beat expectations and some companies have reinstated earnings guidance which is a positive in removing some unknowns. 3Q earnings estimates have improved and are expected to be less bad with consensus estimates of -21.2% and -3.6% year-over-year (Y/Y) decline in earnings and sales, respectively. The calendar year 2020 and 2021 earnings estimates fell slightly last week.




· Europe: Confirmed COVID cases have risen on a W/W basis for twelve straight weeks in the Eurozone and could weigh on the outlook. Infection counts in France and Spain hit another highest weekly infection record. The U.K. pace of infections increased for the fourth week in a row. September consumer inflation (CPI) readings for the Eurozone are expected to remain steady at -0.2% Y/Y. The final scheduled round of European Union (E.U.) and U.K. trade talks are on the calendar this week. The E.U. summit of leaders rescheduled due to COVID will be held Thursday and Friday.







· Asia: China September official manufacturing PMI should strengthen while non-manufacturing moderates, but both should continue to indicate growth. China Caixin manufacturing PMI is expected to hold steady at 53.1. Japan has had seven straight weeks of W/W declines in infections after a streak of increases. Japan Tankan readings for 3Q are expected to bounce off the lows but remain negative. The Japan monthly employment reports for August should see unemployment rise to 3.0% and the job-to-applicant ratio fall to 1.05.



Central Banks: The central banks of Angola, Ghana, Kenya, Bulgaria, Guatemala, India and the Philippines are scheduled to meet with no major central banks expected to change their policy rate.


Week in Review


· Stocks declined by -0.6% for the S&P 500 with three out of eleven sectors higher for the week. Large cap value as measured by the Russell 1000 Value underperformed at -2.8%. Technology (2.1%), consumer discretionary (1.2%) and utilities (1.2%) outperformed the S&P 500, while energy (-8.6%), materials (-4.6%) and financials (-4.2%) were the biggest laggards. WTI (-2.1%) and Brent (-2.9%) oil were higher with MLPs (-8.6%) and the energy sector (-8.6%) outperforming. Small-cap stocks underperformed relative to the S&P 500 with the Russell 2000 lower by -4.0% and small-cap value stocks underperforming at -5.7%. The 10-year and 30-year U.S. Treasury yield were lower at 0.65% and 1.40% respectively.


· High yield credit spreads widened reflecting decreased risk appetite. AAA municipal bond yields as a percentage of Treasuries rose, causing municipal bonds to underperform. The negative revenue impacts of the economic lockdown on local governments and talk of state bankruptcy have driven municipal bond valuations to low levels relative to Treasuries. Allowing states to declare bankruptcy should remain an unlikely outcome with the heart of the issue really about the size and distribution of Federal government aid. Additional support for the states is likely to come in any future stimulus bills.


· The U.S. dollar was stronger against both developed and emerging market currencies. Developed international stocks as measured by MSCI EAFE underperformed the S&P 500 returns in U.S. dollar terms (-4.2%) and on a hedged-currency basis (-2.3%). MSCI Japan underperformed the S&P 500 returns in U.S. dollar terms (-0.7%) and on a hedged-currency basis (-0.7%). Emerging market stocks outperformed the S&P 500 with the non-hedged return of -4.5% for MSCI EM.


· The 10-2 yield curve narrowed to +52 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield fell to +5 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen more than a year in advance of an economic recession and external shocks like the current coronavirus-induced recession might not be accompanied by one. Stocks have historically had significant advances post-inversion.


The PDF version of Stone's Weekly Market Guide is linked here.


The Guide to the U.S. Reopening Monitor is linked here.


The weekly update to the U.S. Reopening Monitor is linked here.

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