Investment Managers See Opportunities in Small-Caps

They say the Federal Reserve’s fiscal and stimulus moves have put a floor under the equity and bond markets.

During a webinar Thursday, “The Road Ahead—Market Recovery, Economic Growth and Decoding the Investment Landscape,” moderator Joe Terranova, chief market strategist at Virtus Investment Partners, said because the equities market declined by more than 30% between February 19 and March 23, what is happening to the markets and the economy “feels similar to the Great Depression of 1929.”

However, Terranova was quick to add, “It is important to communicate that the economic and market conditions are different.” In 1929, he said, fiscal policymakers made limited moves, and monetary policy makers removed liquidity by nearly 7%. Trade with Europe declined by 65%.

“The crisis of preservation of 2020 is completely different,” Terranova said. “The government has responded to it with a mosaic of coordinated moves,” most notably with fiscal support that is 14.5% of GDP (gross domestic product). This, he said, has “provided stability to capital markets and an environment for investors where they can think about diversification in terms of asset class, geography and equity size.”

Asked whether he thinks there is a disconnect between the economic reality caused by the coronavirus and the stock market, Peter Mallouk, president of Creative Planning, Inc. said he did not. “You see the market going up,” Mallouk said. “That is exactly how connected the market is to the economy. The market is a leading indicator. Look at any sector in the market. They are a great proxy for what is going on.”

Things appeared to be totally deteriorating in early- to mid-March, Mallouk said. “The virus was spreading rapidly with no cure in sight,” he said. “Experts were saying that a vaccine would take a few years, and it appeared that Americans might not go fully back to work for six months to, perhaps, a year. Airline and hotels could go out of business. Large-cap stocks were down about 34%, and small-caps down much more. We saw the bond and the stock market falling apart.”

But, within three days of the Federal Reserve stepping in as a back stop, the market rose 21%, Mallouk said. “Some of the existential threat was removed,” he said. “There was no run on the banks. Today, sectors are all where they are supposed to be. The lay person doesn’t understand that the market is the leading indicator.”

David Albrycht, president and chief investment officer of Newfleet Asset Management, said investors should be heartened by the “significant, aggressive monetary response of the Federal Reserve.” As a result, the leveraged-loan, high-yield and investment grade bond markets have made quick recoveries.

At its low on March 20, the high-yield bond market was down 20%. Today, that is less than 7% down, Albrycht said. As to where opportunities lay in the fixed income market, it is “active management versus passive,” he said. “We are playing a lot of sectors, including corporate and muni. In the intermediate term, fundamentals are suffering, but we see a recovery in the rest of the year.”

J. Patrick Poling, managing director, Southern Oak Wealth Group, said emerging market and small-cap stocks typically lead other stocks when coming out of a downturn or a recession. “In the past 70 years, they have outperformed nine out of 10 times,” Poling said. However, with the emphasis in the United States on bringing back more overseas manufacturing, as the virus revealed our overdependence on China in particular, Poling said in this recovery, he foresees small-cap stocks outperforming emerging markets stocks. “We will be deriving more revenue within our borders in the next one to two years,” he said.

However, Poling suggested it is important to look for small companies that can survive this crisis. “In all likelihood, it will not be the mom and pop restaurants,” he said.

Regarding the bankruptcies and negative news, George Schultze, managing member and founder of Schultze Asset Management, said that before the the COVID-19 virus, there were some companies that were overleveraged, but not much activity in distress investing. Today, there is more than $1 trillion in distressed debt, a spike caused by industries, such as travel and cruise lines, that have been tremendously impacted by social distancing. Schultze said he expects more companies to file for bankruptcy.

Mallouk noted that the QQQ exchange-traded fund, which tracks technology companies, has traded to an all-time high. That is because these companies have benefitted from people being quarantined at home and relying on technology, he said. “If you take big tech out of the S&P 500, it is more of a U-shaped recovery,” Mallouk said. “I am somewhat optimistic that we won’t be back in quarantine. The S&P 500 is very deceiving when the top five stocks make up more of the market cap than the bottom 350 stocks.”

As far as his outlook for the municipal bond market, Albrycht said, “We like the muni market because someone has to pay for the fiscal stimulus, and it will be the taxpayers.”

In the equities market, Mallouk said he likes small-caps and government-backed securities. “The uncertainty is already priced in,” he said. “I think the market is where it is supposed to be. COVID-19 is under control, and we will have promising treatments or a vaccine soon. My advice is, bring back your investing to your objectives for the next one, five and 10 years. There are a lot of things on sale here.”

Schultze said there are three approaches his firm is taking right now: “We are short selling equities heading into trouble, investing long in distressed debt, and buying post-distressed equities. Those are the three continuums we like to rotate the portfolio through. There is $1 trillion worth of new distressed debt. There is a lot to pick through the rubble. Have an activist focus, because the recovery will be complex.”

As to whether the massive government stimulus and fiscal support could result in a “massive inflationary shock,” Schultze said that is “definitely a risk. While inflation statistics are low right now, an insane amount of money has been printed in the last eight weeks. We bought some silver before COVID-19, and it has done well.”

To generate income in this low-yield environment, Mallouk said, “It is tough right now, especially with where bonds are right now. A 20-year municipal bond is paying 1.5%. We prefer preferred stocks, but you have to be picky. The financial and utility sectors are promising, as are REITS [real estate investment trusts], but not the commercial real estate that has to do with retail. We like data center REITs. They are paying above the S&P 500 dividend average.”