This week’s headline risk comes courtesy of the Old Institution and their obsession with “valuation” as the holy grail of investing and trading criteria, says Landon Whaley of Whaley Global Research.
According to Bank of America’s Jill Carey Hall, investors have the “best valuation entry point for small caps since March.” She cites that small caps are trading at a 26% discount to “large peers,” which is the widest spread in the last 20 years.
Oh man, don’t you want to back the truck up (beep, beep, beep) on small caps? How good does it feel when you get a bargain, especially the best deal in 20 years?! Before you open up your Robinhood app and start buying “cheap” small-cap stocks, as my ex so eloquently put it, “we need to talk.”
Erroneous, Erroneous on All Accounts
The problem with the valuation argument is that equity markets don’t rally (or decline) because of valuation. People don’t wake up one morning and suddenly decide that a -26% discount to large-cap stocks is a valid reason for owning stock in the smallest companies available.
Here, we pause to make a request of Buffett disciples who make the annual pilgrimage to Omaha to kiss the ring and spend their weekends sifting through company balance sheets looking for the diamond in the rough: please keep nasty emails and passive-aggressive tweets to yourself.
I’m not implying that valuation isn’t a useful metric as one component of specific investment strategies. But what I am saying, unequivocally, is that using valuation as a primary driver of investing decisions is like using the Super Bowl to determine the stock market’s future direction.
Give Me the FG and Nothing but the FG
As is usually the case, Jill Carey Hall and the rest of Wall Street never understand that the risk and return of asset classes are entirely determined by the underlying fundamental gravity. If the prevailing FG environment is bearish for the asset class in question (in this case, US small-cap stocks), then the “cheap” get “cheaper.”
We’ve been bearish on US small caps since late September 2018 because the US economy has been toggling between fall and winter fundamental gravity environments. For those that are new to this FG concept, small caps are among the worst-performing equity sectors in fall and winter FGs. Look no further than the last two years to confirm this point.
Since US growth began slowing in Q4 2018, the Russell 2000 Index (RUT) has returned -0.40%. Not only that, but small caps have crashed (peak-to-trough drawdowns in excess of -20%) on two separate occasions Q4 2018 (-24.1%) and March 2020 (-41.1%). Beyond those two crashes, small-cap investors experienced three individual corrections of at least -10% and another five occurrences when losses exceeded -5%. In short, these “cheap” stocks have delivered nothing but downside risk since October 2018 because the prevailing US fundamental gravity has been bearish for small caps.
The Bottom Line
Valuation has nothing do with how an asset class performs, unless and until the underlying FG turns bullish for that asset class. Once the FG environment transitions from bearish to bullish, that’s when asset classes with favorable (“cheap”) valuations can kick it into high gear and outperform on the upside.
The headline risk bottom line is that it's critical to anchor your decision making in the fundamental gravity and not the “valuation.” We are in a winter fundamental gravity here in the US, which means small-cap stocks are no-go operation until further notice. While we wouldn’t touch these filthy varmints with a 10-foot pole on the long side, we would be opportunistically attacking small caps on the short side.
To learn more about Landon Whaley, please visit WhaleyGlobalResearch.com.
