Disconnected Defensives

Small-cap stocks

Disconnected Defensives

Defensive sectors like Health Care have led small caps this year, suggesting that the market may be growing disconnected from economic realities. But a shift back toward cyclical sectors could be in the offing.

Recognizing the disconnect

So far in 2017, we’ve seen economically sensitive cyclicals (Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials) continue to underperform their defensive counterparts (Consumer Staples, Health Care, Real Estate, Telecommunication Services, and Utilities).

Health Care has driven this year’s returns for defensive sectors (as was the case in 2015), while within the sector biotechnology stocks have led, as was also the case in 2015.

Earlier in the year, the lead for growth stocks suggested a consolidating market to us, one in which last year’s winners (that is, cyclicals) reversed roles with 2016’s disappointments (healthcare stocks having corrected in 2016).

Nearly three-quarters of the way through the year with growth’s leadership still firmly in place, we are beginning to see the current U.S. stock market as disconnected from what’s happening in the economy.

Both stock and bond investors appear to be pessimistic. The yield on the 10-year Treasury has been falling through most of the year, which typically (though not always) signals concerns about economic growth, just as investors’ preferences for more duration and defensive investments often does.

Why we're more optimistic

While we see ample uncertainty, we also see more than enough reasons to be cheerful about economic prospects—especially on the global level.

To begin with, 2017 looks nothing like 2015 to us. We have an expanding global economy, the possibility of improved GDP growth in the U.S., and no one is talking seriously about looming recessions.

So while almost no one seems excited by the slow rate of U.S. economic growth, we think it’s important to note that our economy is growing—and even at “this petty pace,” slow growth beats contraction or flatlining.

Equally important is the improving global picture. Japan recently reported its best quarterly GDP numbers in more than two years, lifted by consumer and CAPEX spending; the eurozone, unresolved Brexit issues notwithstanding, continues to do well, and China’s strengthening currency is another in a series of signs that its economy is roaring back.

Of course, valuations are high for many stocks across the market cap spectrum. Yet we looked at the 15-year average of the so-called Enterprise Multiple (EV/EBIT*) for the Russell 2000 Index, separating the metric into cyclical and defensive.

Enterprise Value* for Russell 2000 Index: 15 Year Average vs. 6/30/17

Source: Factset.  Cyclical sectors are Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials.  Defensive sectors are Consumer Staples, Health Care, Real Estate, Telecommunications and Utilities.

The average for cyclicals is running a little higher than its long-term average, but still looks much better than the average for defensives—which are running substantially higher.

We think solid-to-strong prospects for the global economy, along with relatively more attractive valuations, should mean good things for a certain kind of small-cap company.

From our perspective, small-caps in cyclical industries with global exposure look poised to lead —and we are happy to be holding many. Stay tuned…

 

** EV/EBIT is Enterprise Value divided by Earnings before Interest and Taxes -- commonly known as the "Enterprise Multiple" ratio, typically used to gauge the value of a company

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