Continuing To Favor U.S. Large Cap Stocks Over U.S. Small Cap Stocks

With the passage of tax reform, one market segment one might believe experiences an outsized benefit to earnings is U.S small cap stocks. This certainly seems plausible due to the fact smaller companies tend to have less direct exposure to foreign revenue; therefore, likely generating most of their profits in the U.S.

Our firm exited completely the U.S. small cap space in late 2013 based on a number of factors, with one being the relative valuation of small cap stocks versus large cap stocks. Reviewing the relative valuation of small caps versus large caps based on price earnings ratios has certainly turned to favor small over large as can be seen in the chart below.

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Small Businesses Remain Highly Optimistic

Tuesday's report by NFIB on small business optimism for the month of January places the reading in the top five highest coming in at 106.9. According to NFIB the response to "Now Is A Good Time To Expand" was 32% and is the highest level for this category in the Indexes 45-year history. Today's strong NFIB report comes on the heals of a record level of optimism in 2017. NFIB President and CEO, Juanita Duggan noted,

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Enhancing Investment Results By Utilizing An Investment Mentor

In a recent article, Strong Hands - Bridging the Behavior Gap, by Pim van Vliet, PhD, a Managing Director at Robeco Institutional Asset Management, it was noted that,

"the average mutual fund investor lags a buy-and-hold strategy by -1.9%. This finding is persistent across different styles, varying from -1.3% for value investors to -3.2% for growth investors. Also 'passive' investors in market funds underperform a buy-and-hold strategy by a whopping -2.7%."

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Dow Dogs Struggle Early In 2018

The Dogs of the Dow of 2018 include two newcomers, General Electric (GE) and Procter & Gamble (PG). These two stocks made the list of top 10 dividend yielding stocks in the Dow Jones Industrial Average Index for 2018 and replaced Boeing (BA) and Caterpillar (CAT). Unfortunately the new additions are weighing down the performance of the Dow Dogs so far this year as they are the worst performing stocks out of the ten Dow Dogs year to date through Friday's market close.

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Last Week Was The Beginning Of An Equity Market Returning To Normality

Some are saying last week's market movement is one for the record books. I have seen descriptions noting the market decline was unprecedented or the market is in turmoil. S&P Dow Jones Indices Indexology Blog titled a post, I'm Exhausted, but outlines data that places the market decline in perspective. One data point in S&P's post,

"Keeping perspective, as repeatedly noted, while 1000 point declines make for frightening headlines, the percentage changes represented by those moves are not uncommon. To wit, there have been nearly 300 daily 4% or greater moves since the DJIA’s inception. Put another way, 3 of the top 10 worst point drops on record occurred during this recent spell; none of them, however, come anywhere near the worst percentage."

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A Reversal In Bullish Investment Sentiment

I have often written that sentiment measures are most valuable at their extremes. Also, they tend to be most representative of potential market turning points when the extreme is at the bearish end of the spectrum. However, in hindsight, it appears recent excessive bullishness for individual investors and institutional investors indicated a cautionary equity market outlook would have been profitable.

The first chart below represents individual investors' bullish sentiment responses as reported weekly by The American Association of Individual Investors. On January 4 of this year bullish sentiment spiked to near 60% and represents a high level for this reading. About a month later, the 8-period moving average reached near 51%, also a high level for the 8-period average, although the average has exceed 60% in the past. 

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Volatility Returns

Unwelcome, Unpleasant, Inevitable. The recent spike in volatility has certainly caught the attention of investors over the past several days and as corrections go, the market drop has been quick and sharp. 

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Pullbacks Are A Normal Part Of A Bull Market

During the Fed's move to increase short term interest rates, some have expressed concerns due to the yield curve's increased flattening, i.e., short rates moving higher versus long term interest rates. This increased flattening move can be seen in the below chart and the concern centers around the fact that every recession since 1960 has been preceded by an inverted yield curve, i.e., short term rates higher than long term rates. The move by the Fed to push short term rates higher is part of a normal process to get interest rates back to a normalized level.

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Will The Stock Market Ever Decline Again?

For many investors it may seem difficult to believe since it has been so long ago, but the equity markets do go through negative returning periods. The average intra-year decline for the S&P 500 Index since 1980 is 14% and the last double digit decline was in February 2016, nearly two years ago. So what in the world is going on that has stocks in what seems an uninterrupted climb?

The below 'monthly' chart shows the S&P 500 Total Return Index since the beginning of 2016. Over the course of the two years, 2016 and 2017, the S&P 500 Index has experienced only three negative returning months (red bars) with no down months in 2017. The last bar on the chart represents the January 2018 return and the start of this year has been decidedly bullish.

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A Balancing Oil Market, But Will It Last?

In May 2011 crude oil (WTI) hit $113 per barrel and remained elevated at or near that level until the summer of 2014. Given the high price of crude and the expansion of fracking at that time, crude supply continued to grow until peaking in mid 2017. I wrote about the high crude supply level in mid 2017 and its impact on keeping oil prices down, Higher Oil Prices Contend With Too Much Supply And Higher Energy Efficiency. Today, we are seeing crude oil inventory decline at a fairly rapid rate as can be seen with the green line in the below chart.

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Investor Sentiment More Actionable At Market Bottoms

Today's weekly AAII Sentiment Survey reports a drop in bullish investor sentiment of 11.1 percentage points to 48.7%. The bullish sentiment reading has been on a steady move higher since November 16 when the bullishness reading was 29.4%. The weekly readings tend to be more volatile and one can look at the 8-week moving average in order to eliminate some of this volatility. As a result, although the sentiment reading fell this week, the longer period average of bullish sentiment increased to 45.6%, largely due to dropping the 29.4% bullishness reading from November 16.

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Winter 2017 Investor Letter: An Uninterrupted Climb

Our Winter 2017 Investor Letter provides commentary on 2017 and our thoughts and observations on the coming year. Many strategists and investors have either commented on or know from first hand experience, in 2017 the equity market saw very little downside market volatility. Our expectation for 2018 is the market will see a more normal level of volatility. As we comment on in our Investor Letter, that normal level of volatility would be a 14.1% decline from peak to trough. A decline of that percentage amount would equal 3,500 Dow points, and that would represent a normal pullback.

For additional insight into our views for the market and economy in the coming year, see our Investor Letter accessible at the below link.

• Winter 2017 Investor Letter

High Beta Stock Outperformance Suggests A Strengthening Economy

For the first part of 2017 low volatility equities were outperforming their high beta counterparts. However, as tax reform talk began to look more a reality in late August, high beta stocks resumed their outperformance that really began in early 2016. As the maroon line in the below chart shows, this high beta outperformance is carrying over into the beginning of 2018.

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Sentiment: Simply More Buyers Than Sellers

I am re-reading Justin Mamis' book, The Nature of Risk, a worthwhile read by the way, and being reminded of the dissemination of information prior to the internet age, which is difficult for many to believe if they did not work in investments at that time. Simply gauging market sentiment prior to each day's market open at that time was much different than it is today, of course. As he notes in his book, when one inquired about, say, a higher market, the most appropriate answer was there simply were "more buyers than sellers" that day. In today's proliferation of business cable channels, that type of response will not sell many advertisements.

This focus on buyers and sellers is really an evaluation of investor sentiment and is one reason I write about sentiment reports on a fairly regular basis. To that end, the American Association of Individual Investors reported Sentiment Survey results last week and individual investor bullish sentiment jumped 7.1 percentage points to 59.8%. Most of this bullish improvement came from the prior week's bearish survey participants as bearish sentiment decline 5.1 percentage points to 15.6%. This spike in bullish sentiment can be seen in the below chart.

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Dow 30,000 By Year End

The Dow Jones Industrial Average pushed through 25,000 in the first week of 2018. True to form, the President weighed in on this record and indicated 30,000 is the next target, skipping over the 1,000 increment target milestones. His comment was replayed numerous times on television by the financial media Thursday with many commentators spinning his comment as hyperbole, but might a Dow target of 30,000 in 2018 be reasonable?

The below chart displays the calendar year returns for the Dow Jones Industrial Average going back to 1980. Also included on the chart are red dots representing the largest intra-year drawdown or decline. Looking at the mid 1990's returns, there was a five year period, 1995 - 1999, where the Dow returns ranged from 16% to 33%, but with four of the year's return above 20%. So what would it take for the Dow Index to hit 30,000? A 20% return.

The point being, with the Dow Index trading at a large absolute number level, these 1,000 or 5,000 point moves are not out of the realm of even a reasonable possibility. Just as today a 100 or 200 point decline in the Dow is not a significant drop at all, i.e., less than a tenth half of a percent. Importantly for the market and investors though, is the fact the market has not experienced a double digit pullback since February of 2016, nearly a two year period. The market will experience one of these double digit declines as it did 1997 and 1998, but looking at those prior years, the market can recover and generate strong returns for the entire calendar year period.

Equal Weighted Equity Performance Lagged In 2017

One equity market phenomenon that played out in 2017 was the fact larger capitalization stocks were larger contributors to market returns. One way to evaluate this is to review the return of the cap weighted S&P 500 Index versus the equal weighted Guggenheim S&P 500 Index (RSP). As the below chart shows, the equal weighted index underperformed the cap weighted S&P 500 Index by more than 300 basis points. Additionally, the largest 50 stocks by capitalization (XLG) outperformed both the the S&P 500 Index and the equal weighted S&P 500 Index.

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Is The Glass Half Full Or Half Empty

The end of Friday trading was certainly interesting as the last thirty minutes of the trading day incurred most of the day's half of a percent loss. A few Twitter posts I read were comments in the vain of "this is the selling I have been anticipating." The market is over due for a pullback.

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Most Read Articles From Our Blog In 2017

Below is a list of the most read blog articles in each month during 2017. One interesting commonality for some of the top posts is the fact the ones focusing on investor sentiment tend to gain higher levels of readership. Sentiment is one important market factor we monitor on a fairly regular basis. Secondly, some prior articles seem to remain applicable as 2018 is set to begin. For example, articles like Market Pullbacks Should Be Expected and The S&P 500 Index Is Expensive and Has Been So Since The Early 1990's are certainly timely even today.

Our firm's bullish equity stance in 2016 and 2017 has certainly rewarded our clients. We are in the midst of finalizing our Winter Investor Letter which will contain some of our firm's thoughts on the coming year.

To our clients and readers, we wish all of you a Healthy and Prosperous New Year.

Second Longest S&P 500 Rally Since 1932 - January 25, 2017

Recent Outperformance Of Low Volatility A Sign Of Risk Off Ahead? - February 12, 2017

Time To Reduce One's Equity Exposure? - March 1, 2017

Widespread Bearishness Indicating Market Nearing A Turning Point? - April 14, 2017

The Unfortunate Rise Of The Misleading 'Scary Chart' Comparisons Again - May 29, 2017

Market Pullbacks Should Be Expected - June 26, 2017

Strong Earnings Growth And Favorable Valuations Lead To Weak Stock Returns - July 22, 2017

The S&P 500 Index Is Expensive And Has Mostly Been So Since The Early 1990's - August 5, 2017

Stocks Need Some Healthy Competition - September 16, 2017

Citgroup Economic Surprise Indices Have Little Bearing On Equity Market Performance - October 15, 2017

Individual And Investment Manager Sentiment Is Diverging - November 2, 2017

If Cash Is King - December 19, 2017

Continued Improvement In Bullish Investor Sentiment

In the few weeks after the 2016 presidential election, individual investor bullish sentiment spiked to near 50%. Over the course of the next five months though, bullish sentiment trended lower to a year low of 23.85%. From March through April the market had some volatile periods that may have influenced investor sentiment; however, true to form this year, the market never experienced a prolonged or significant contraction.

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Dogs Of The Dow Make Up Ground In Second Half Of This Year

Four trading days left until the calendar turns to 2018 and one will be able to determine the list of stocks that will comprise the Dow Dogs of 2018. The Dow Dogs were laggards in the first half of the year, but have made up significant ground in the second half of 2017. To date the Dow Dogs of 2017 have outperformed the S&P 500 Index on a total return basis due to the Dogs higher dividend yield. However, the Dogs of the Dow have underperformed the Dow Jones Industrial Average Index on both a price only and total return basis. The best performing Dow stock that is not included in the Dow Dogs this year is Apple (AAPL) and the stock is up 51.1%.

The Dogs of the Dow strategy is one where investors select the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor invests an equal dollar amount in each of the ten stocks and holds them for the entire next year. The popularity of the strategy is its singular focus on dividend yield.

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As of Friday's close both Boeing (BA) and Caterpiullar (CAT) will drop out of the Dogs for 2018. The two holdings in the running for inclusion in next year's portfolio are Procter & Gamble (PG) and General Electric (GE) with dividend yields of 2.99% and 2.74%. respectively.