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In observance of Memorial Day, the offices of Rollins Financial and Rollins & Associates will be closed on Monday, May 26th. Please note that all major U.S. stock exchanges will also be closed in honor of those who died in service to our country.
If you require immediate assistance on Monday, please contact Joe Rollins at 404.372.2861 or jrollins@rollinsfinancial.com. Our office will re-open for business on Tuesday, May 27th at 8:30 a.m.
Please be safe, and have a great holiday weekend!
Best regards,
Rollins Financial, Inc.
From the Desk of Joe Rollins
The month of April was a mixed performance for the major market industries. While the S&P 500 actually ended up 0.7% (less than 1%), the NASDAQ Composite lost two full percentage points (-2%). The Dow Jones Industrial Average was up 0.9%, but the Russell 2000 Index lost a healthy 3.8% during the month of April. For the year, the S&P was up 2.6% at the end of April, the NASDAQ Composite was down 1.2%, the Dow Jones Industrial Average was up a marginal 0.7%, but the Russell 2000 for the year was down 2.8%. Surprisingly, the Aggregate Bond Index was up .9% during the month of April, and year-to-date gains are 2.8% for this broad index.
While certainly nothing spectacular happened during the month of April, underneath the broader index there was a major sell-off in small and mid-cap stocks, which I would like to discuss since many of our clients hold these mutual funds. It is certainly surprising that the Bond Index continues to rally in the face of what I suspect will be an increase in interest rates as the year progresses. Within the broad spectrum of investments, I fear bonds the most. We know at some point the Federal Reserve will further reduce their buying of bonds in the open market and begin to increase interest rates. When this happens, it is likely just a matter of when, and not if, many bond funds will lose money.
Often times, things occur in financial markets that there is no explanation for and you just have to accept it as the reality of a willing participant. However, this sell-off of small and mid-cap stocks of nearly 15% in the last 30 or 40 days has been pronounced and has made me really wonder whether there was something deeper going on in the markets that I had not noticed.
While the broader large-cap stocks have been relatively stable, the small-cap and medium-cap stocks have been unfairly punished. The S&P 500 is up 2.3% for the year 2014 through May 9, 2014. While certainly not a sterling gain, it is still acceptable considering the huge 32% gain we enjoyed during 2013.
Some small-cap funds have sold off in excess of 15% in this relatively short period of time and I wanted to do some research to see if I could make sense of this bloodbath that occurred. Both small-cap and mid-cap (mid-cap to a lesser degree) stocks provide a truer reflection of the U.S. economy, compared to the larger companies contained within the S&P 500. These huge large-cap stocks have operations around the world and function in many companies, many currencies, and deal with the economies of the world, and to a lesser degree the U.S. economy.
In contrast, the small and mid-cap stocks are generally U.S. based companies that reflect only the U.S. economy. Virtually every economist is forecasting the U.S. economy to improve throughout the rest of the year. Even though the first quarter of 2014 has recorded a GDP growth of virtually zero, most economists are blaming that on severe weather. Even the Federal Reserve is projecting the U.S. economy to have close to a 3% GDP growth in 2014. While I am not as optimistic as that, I still think 2.5%-2.8% is a realistic calculation of GDP for 2014.
If the first quarter GDP growth was virtually zero, then by definition the economy would have to accelerate quite rapidly in the following three quarters to reach a 2.5% GDP for all of 2014. In my opinion, that is exactly what will happen. After seeing the severe damage that the harsh winter did to businesses, it is not unrealistic to assume a significant improvement in the economy is imminent.
If that is the case, why have mid and small-cap stocks been so unfairly punished? Ever since the GDP was announced for the first quarter, there has been a substantial decline in these stocks based upon the assumption that GDP growth would still be timid or negative. Knowing that there is no substantial support for that opinion, I was perplexed that this sell-off occurred so quickly and dynamically in a relatively short period of time.
Every week I study the financial statistics in Barron’s. I look at both the performance of various financial instruments as well as the momentum of individual sectors and try to determine what is affecting them. This sell-off is even more mind-boggling when you see that economic statistics continue to remain strong. The 2014 first quarter earnings were up and once again set an all-time record for corporate earnings, leaving no justification for the sell-off based on earnings and the economy as a whole. When you have all three positive attributes as we have today - very low interest rates, earnings that are accelerating as well as an economy that appears to be on the uptrend and increasing- stock prices should be higher not lower. Therefore, I found it more surprising than ever to see this large sell-off in the small and mid-cap stocks.
When I searched Barron’s looking for a solution to the conundrum of positive attributes with lower stocks, I came across a very interesting financial fact. As of April 30, 2014, there was a short interest in the Russell 2000 ETF of almost 156 million shares. To most people this would seem like a meaningless number, but when you multiply out the value of that ETF, you find out this is over $17 billion. And even more surprising, that entire ETF only has $27 billion in assets. Therefore, currently 63% of this very important ETF has already been shorted. A technical explanation of shorts is very important to understanding this analysis.
When you short a stock, essentially you sell a stock you do not even own. The financial markets allow this treatment since it tends to keep the market regulated and gives a ready seller the opportunity to sell with a ready buyer. The major difference in buying a stock long and shorting the same stock is the amount of risk taken. Risk, for the average investor, would never allow one to short stocks as the risk involved is unlimited.
If you buy a stock for $10, the most you could lose is $10. However, if you short a stock for $10, your loss could be exponential. The stock could increase to $20, $30, $40, etc. Therefore, shorting a stock is the riskiest form of investment and is usually isolated among very sophisticated investors or hedge funds that specialize in this aggressive yet risky form of investing.
If you really want to know why the small-cap stocks took such a major downturn, this would be my explanation. Hedge funds as an industry have struggled over the last few years to compete with the large gains realized by the broader passively invested indexes. If you are charging the outrageous fees that hedge funds charge, then by definition you have to take risky bets to increase your returns. It seems that as an industry many have decided to short the small-cap stocks all at the same time. When you have a 63% short ratio on only one ETF that specializes in the Russell 2000, you can see the enormous downward pressure they create on this individual index. Even during the month of April, these shorts increased by an excess of $2 billion.
While this may explain why the stocks underperformed when the financial conditions did not warrant such an under-performance, there is actually a bright future for the index. People who short stocks eventually have to cover those shorts. When they do so, they have to purchase the index in order to cover a short. Therefore, at some point you will see a mad rush for the shorts to get out of their positions by purchasing the same index that they previously sold.
This built up demand could cause the index to move up very quickly when you many not see any reason for a quick move to the upside. When shorts all rush out the door at the same time, it becomes a game of chicken. Which fund will elect to be short if everyone else is covered and the index is moving up quickly? I think the bottom is near and the index should move higher from here.
With all this said, it appears that nothing in the economy or the valuations of business has led to this swift sell-off. From the research, it looks to me that traders alone are pushing the index down for their own special benefit. Since this move is short-term and we are long-term investors, I do not anticipate any changes in our allocation to these indexes over the near term. While we will certainly watch them closely and look for any inconsistencies in performance given the change in economy, I cannot see any change that warrants us moving or changing our long-term investment horizon at the current time.
While the market has certainly been volatile, none of this could be unexpected given the huge gains that we enjoyed in 2013. Even the small-cap index is up over 130% over the last five years and moved over 30% higher in 2013. While you would certainly expect there to be a sell-off as investors reallocate resources to other sectors, I currently am not convinced this move is warranted.
There may also be a hidden explanation as to why the bonds are rallying. Even with the almost assurance that the interest rates will increase as the year progresses, I cannot help but think that the shorts, which sold stock they did not own, may have parked that money in bonds as a safe haven until they cover these positions. If that is the case, the move up in bonds and the move down in small and mid-cap stocks is a false alarm and as an investor, you should always fear such swift movements that are not supported by economic reality.
As the economy strengthens throughout the year, I would expect the small-cap and mid-cap U.S. stocks to perform at even a higher level than the large-cap international stocks. Since we hesitate to make short-term moves, I suggest we wait this one out and see what happens in the next month or so.
As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
Best regards,
Joe Rollins
