Quick Update On the Market Ahead

This past quarter was interesting for market returns. The S&P 500 was essentially flat (up about 1%), while mid-caps were down about 9% and small-caps were down about 11%. This sort of phenomenon is common as markets begin to correct. The first stocks to drop are the one investors see as riskier and then the larger stocks follow. Of course, this is one of those investor actions that strays from the rational; as we saw during the Great Recession, small-caps carry no more long-term risk than large-caps, but they are more volatile in the short-term. So, indications point to a corrective period, although the market can always move in unexpected directions (and often does).

What does this mean for client portfolios? In the short term it means that we’re going to give up some ground against the S&P 500. Client portfolios are mostly made up of mid and small-caps because that’s where the best value can be found. This drop is, however, actually a good thing. With a focus on the long-term, a short-term drop means that we will have much better value opportunities, and we currently have the cash to take advantage of them.

I plan to start using cash and moving toward full investment in client portfolios soon. There are already better values available, and I expect that to continue. The market may move in an unexpected way, but given overall market values, and the volatility in smaller stocks, it looks like we’ll have excellent opportunities in the coming months. The goal isn’t to catch the bottom (such market timing is impossible), it is to find excellent long-term value and then ride out any short-term turbulence.

Investors always seem surprised when corrections happen, but it’s all a function of human psychology. While such events often push people into bad decisions, smart investors see them for the opportunities that they are. And they happen over and over again.

  1. If you know that the market is going to drop, why not sell everything? Why would you want to “give ground against the S&P 500”. Value investing seems silly if you let yourself lose money.

    • Thank you for the question George. Expecting something to happen in the stock or bond markets and knowing it will happen are two very different things. These markets are irrational in the short-term, so it’s impossible to know how they respond to any given set of events. Thoughtful investing is about balancing risks and rewards. So, if the market shows an indication that it might move in a direction, a prudent investor might make a small move to prepare for that. Wall Street is full of portfolios broken by investors who were sure the market would move in a direction, bet all their capital on that move, and it never happened. I always proceed in a measured way and I never veer too far away from my long-term steady value investing approach. If you see an edge the markets are providing you, take it; but go slowly, and use caution. Whatever indicators you thought you found can vanish quickly.

  2. Mr. Aram, you write that client portfolios are mostly made up of mid and small caps because that’s where the best value can be found. Is it because there are not too many large companies that are undervalued at this level of the market? Or do you think that small and mid caps always present better opportunities than big companies do?

    • Thank you for the question Rima. Basically, small and mid caps are ignored by most investors, thus there is more volatility, which creates more inefficiencies than with large cap stocks. This happens for two big reasons, investors view small caps as more risky (which is true in the short-term due to volatility, but not so true in the long-term), and large investors, like Warren Buffett’s Berkshire Hathaway, have too much money to invest in small and mid caps (the market cap is often smaller than the minimum investment needed to justify the time and energy spend valuing the stock).

      There are exceptions and times when small caps are overvalued compared to large caps. That’s not the case right now as large caps have had a good year, but small and mid cap prices have not appreciated as much.

      The bottom line is that a value investor looks for inefficiencies in the market and small and mid caps generally offer more such opportunities than large caps.

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