This market rally just keeps on going…or does it? It really depends on how you define “the market.” Over the last 13 weeks the S&P 500 has risen more than 6%. However, over that same time period, the Russell 2000 is up less than 1%. It has been a long time since we have seen this much divergence in the market.
The headlines are all positive because they focus on large corporate America as represented by the S&P 500 or the Dow Jones Industrials, but the stocks of smaller companies represented in the Russell 2000 have gone virtually nowhere. Why is this?
We believe there are two main causes. First, the upward movement of the large cap indices over the last few weeks seems to be all about the dollar. The value of the dollar drops and stocks go up, but only the headline-grabbing large cap stocks have benefitted. The reasoning goes that large caps are primarily global companies that do a great deal of business outside of the US. A weak dollar helps these companies export their goods and services as it lowers the cost for foreign buyers.
We do not believe this is a sustainable trend. First, this is really a currency trade, not an investment theme. Currency movements are inherently unstable, and trying to profit off of them is by nature a short-term proposition. Furthermore, strong companies that represent solid long-term investment opportunities have competitive advantages that allow them to compete globally regardless of currency trends. The companies that are really helped by currency movements, beyond a short-term accounting boost, are companies that compete solely on price, for example: commodity producers, who do not offer a differentiated product or service. As a result many top-quality companies, including many smaller organizations, have been left out of this trade.
In addition to the weak dollar trade, the second factor in this market divergence is the mixed signals we are getting from the economic data and from policy makers. Retail sales were better than expected but the jobs report was bad. While the weakness in the job market, and thereby the economy, may actually fuel the weak dollar trade, it hurts the long-term prospects of domestic companies. Unfortunately we also are getting mixed signals about priorities and the future of policy out of Washington. For example, the Friday before last, President Obama said he was committed to growing jobs. A few days later he committed that the US will lower carbon emissions by the year 2050 to a per-capita level that we last saw in 1875. (Let me just say that I agree with you completely regarding global warming, so there is no need to send me an email on the subject. That is not the point here.) The point is these are two contradictory goals. One cannot grow employment without growing economic output, the unwanted byproduct of which is carbon emissions.
Similarly, just yesterday the President met with the leaders of our biggest banks, instructing that they need to lend more to help get the economy moving. Then he told them they should not be opposed to financial reform that is designed to lead to more responsible lending practices – i.e. no more loans to people who can’t afford to pay them back. So which is it, lend more today or be more responsible about how you run your business by rebuilding your capital and being more careful with your loan policy?
There is nothing new about people in politics promising the proverbial ‘having the cake and eating it too,’ but in our current environment it just seems that much more dangerous. What is really scary is that there does not seem to be any understanding that these goals are in conflict with one another. Our political leaders, more than ever before in our history, are career politicians who lack the real-world experience that leads to understanding the ramifications of their decisions, and perhaps more importantly lack the maturity and gravity required to make tough unpopular decisions. So instead, we get mixed signals.
Mixed signals lead to uncertainty, which leads to inaction, which leads to economic stagnation. This is what the market is telling us today. Of course, it may be appropriate to end with a famous quote from Paul Samuelson, the first American to win the Nobel Prize in economics, who passed away this weekend at the age of 94. In commenting on the market’s ability to tell the economic future, Samuelson once said, “The market has successfully predicted nine of the last five recessions.” Let us hope this latest prediction is one of the four bad calls, but we will be prepared just in case.
Chuck Osborne, CFA