A View from the Bottom: Economic Backdrop Not as Bad as Sell-Off Suggests
Portfolio Managers Jonathan Coleman, CFA, and Scott Stutzman, CFA, share their insights on December’s market slide, and where they see opportunity after the sell-off.
- As of late December, stocks are on pace for their worst December since 1931.
- Economic indicators and comments from management teams suggest the economy is on more stable footing than the market fears.
- The market sell-off has been undiscerning, overlooking the durability of many companies’ earnings streams.
Just how bad has it been for stocks in the fourth quarter? Here’s perspective: Late in the month some major stock indices were on pace for their worst December since 1931.
The drop in stocks, particularly small caps, represents an about-face in market sentiment, as many stock prices went from overlooking political, economic and business risks to extrapolating the worst-case scenarios for the broader economy and corporate profits.
As the mood in markets shifts, we believe investors should ask two key questions: Are things really as bad as the sell-off implies, and if not, has the downturn presented opportunities?
The View from the Bottom
We don’t deny that a full-blown trade war between China and the U.S. would be a sizable negative for the global economy. Nor do we deny such an outcome is still a possibility. But the market shrugged off this risk in the first half of 2018, and now prices in a recession. In that same time frame, we’ve seen the China/U.S. trade dispute move from saber rattling to China making some significant trade concessions, such as reducing auto tariffs, that may move the negotiations forward. From that perspective, one could argue the storm clouds are no darker than they were six months ago.
While slowing economic growth has weighed on markets, a bottom-up view from the companies we speak with also suggests a more stable economy than the recent downturn suggests. We recently attended one of the largest annual investor conferences for small-cap companies, and the outlook from executives was broadly positive.
In earnings calls and follow-up meetings with industrial companies, management teams continue to report strong demand in most end markets. This includes end markets such as plastics, which are generally a good leading indicator for the industrial economy. Similarly, other leading economic indicators such as the architectural billings index have shown resilience in the face of broad-based fears of a slowdown.
We generally focus our efforts on finding undervalued growth stocks, not on macroeconomic predictions, but given what we hear from U.S. companies, we believe mild or slow economic growth is a reasonable expectation going forward. And after the recent sell-off, we’re finding an increasing number of attractively valued stocks that could do well in a slow-growth economy.
Market Sell-Off has been Undiscerning
Just three months ago, our biggest concern among small-cap stocks was valuations. Now, we believe the hunting ground among small-cap stocks is more fertile than at any point in the last year and a half. We see the broadest opportunities among industrials and other cyclical companies, some of which trade on single-digit earnings multiples.
We believe the market has taken an undiscerning view among small-cap industrial stocks, selling nearly everything in the sector due to economic fears. Within the sector, we find opportunity in companies with strong aftermarket businesses or other recurring revenue business models that make their earnings streams more durable than current stock prices suggest. We are also finding attractively valued industrial companies in which management teams have deployed technology to improve margins or used historically low rates to improve their debt profile.
Outside the industrial sector, we find stock-specific opportunities in which an overly pessimistic market views even positive events through a negative lens. For example, we’ve seen small-cap biotech stocks retreat after a company announces a positive clinical outcome or FDA approval of a drug. In those cases the stock has traded down because the market was taking a narrow, near-term focus on the company needing to raise capital to commercialize its drug, rather than a positive long-term view on what an innovative therapy might mean for the company’s earnings stream.
We’re happy to take the long view with these stocks, and believe near-term fears will provide long-term opportunities.
Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.