U.S. Value and Small cap stocks still have room to recover
The recent rally over the past two months has been something that has a lot of investors scratching their heads. Even with the tsunami of bad news, April and May were the two best consecutive months for the stock market since 1987. The market is forward looking, therefore, trying to time the market or waiting for “things to blow over” before putting money back into stocks oftentimes causes investors to miss the best days or months in the stock market. So how has the market performed in May and for this year so far, take a look at this chart.
The recovery of the overall market has been led by the tech stocks holding their value and even increasing by over 9%, as shown by the return of the Nasdaq 100. However, by looking at the S&P 500 Value index, those stocks are still down over 14% Year to Date. We have seen a resurgence in value stocks in the trading days this week. This is mainly caused by the reopening of the economy and many believe the rally in these stocks still has room to grow. The value companies are heavily reliant on a growing economy and I believe we will start to see growth again by this fall. This year financial stocks are still down double digits Year to Date, the low interest rate environment has hurt these companies, but as the economy reopens the financial sector could once again return to levels we saw earlier this year. Adding an increase allocation to these value stocks and also small cap U.S. stocks is a good tactical shift to make over the next couple of months. As the U.S. economic picture improves, adding exposure to small caps as well could lead to significant upside over the upcoming months. Making these tactical rebalances to your portfolio can help to increase your chances that you are selling high and buying low.
As you can see from the chart above small cap stocks are still down sharply on a year to date basis. These companies have been hit hardest by the shutdown in the U.S. economy. Making a tactical shift to these sectors can help to boost returns over this next quarter. Historically small cap stocks have lead the market coming out of a bull market. We have not seen the surge in prices thus far but that could change over the coming months. These stocks are still well below their 10 year annualized average return.
This rebound in stock prices has made investors feel uneasy and the recency the decline in stocks has many believing stocks will drop right back down to those levels. However, the rally that we have seen in stocks is normal coming out of a bear market. By looking at the chart below, the 1 year average return after a 20% drop in the market is over 41%. 3 years out from a 20% drop on average leads to an average annual return of 16%.
What about bonds?
2020 has been one of the top performing years for bond investors. This chart shows the return of bonds so far this year and as you can see they are up 5%. This is the importance of keeping a diversified portfolio. The shifts I will be making for my clients over the next couple of months will be into longer duration treasury bonds and short duration investment grade credit.
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