The stock market rotation from large cap growth to small cap value is likely just getting started. Since September, the Russell 2000 value index has trounced the Russell 1000 growth index, up 69.94% vs. 18.69%.*
We believe small cap value is likely in the early innings of a sustained period of outperformance, and believe those that are arguing for a return of large cap growth dominance are misguided. Even after this brief period of small cap value outperformance, large cap growth has outperformed small value since year-end 2016, up 158.08% vs. 53.25%, illustrating that there is still a large performance delta for small cap value to recoup.
The conditions that set the recent small value rally into motion have not changed and in-fact are still accelerating:
A recovery of a supply shock to the U.S. economy caused by the Covid pandemic.
A massive and unprecedentedly large double blast of fiscal stimulus from the government and a massive injection of liquidity and low interest rates from the Fed.
A Supply Shock
As seen in the chart below, pre-Covid, in 2019 and 1Q20, the U.S. was posting solid Q/Q GDP growth of between 1.9% and 2.6%. Post the 2Q20 supply shock induced low of -31.4%, GDP has recovered sharply, up 33.4% for 3Q20, 4.3% for 4Q20 and 6.4% in 1Q21.** There is no doubt that government and Fed support bridged the temporary Covid supply shock, and allowed the economy to recover sharply as vaccines and economic re-openings accelerated.
More to Come
The Fed is sticking to its intention to keep short rates at zero and aggressively buy treasuries, even if this path fuels rising inflation over an extended time frame. Additionally, congress and the administration are likely to pass another stimulus package, focused on infrastructure.
With the economy now resuming its pre-pandemic growth path, many industries are capacity constrained, causing prices to rise dramatically in areas including semiconductors, housing and autos. Said differently, restored demand and tight supply has caused prices, or inflation, to rise.
Inflation is a headwind to growth valuations that are primarily set on discounted cash flow (DCF) valuation models. Higher long-term discount rates, correlated with the 10-year treasury, produce lower price targets in DCF models, especially for those companies that are not expected to produce any free cash flow for several years. Conversely, rising 10-year treasury rates can potentially benefit industrial companies that gain margin enhancing pricing power and for financial companies that earn a higher spread on lending portfolios.
In the Early Innings
As we discussed in our “Mind the Gap” blog (https://www.reweyassetmanagement.com/post/mind-the-gap), valuation levels for small value companies remain substantially below large growth valuation levels.
More easy money from the government and more liquidity from the Fed, combined with accelerating demand from economic re-openings, should continue to support, if not accelerate, the outperformance of small value over large growth.
* The Russell 2000 Value index and 1000 Growth index are both an unmanaged group of securities considered to be representative of the small and large stock market in general, respectively. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index. R2000V and R1000G index performance sourced from Bloomberg.
**Bureau of Economic Analysis GDP data source from Bloomberg.