Quality Time

“You cannot escape the responsibility of tomorrow by evading it today.”
— Abraham Lincoln
 
 
The rate cut by the Federal Reserve in late October was a shot in the arm for investors concerned about recent lackluster industrial economic data. The move was viewed as a needed backstop to prevent a temporary lull from turning into a prolonged downturn.
 
As investors grew more confident that current weakness might be short-lived, they bid the major indices to a string of new highs in late December. The upbeat tone on Wall Street was a boon for lower quality businesses.
 
After spending much of the previous quarter under scrutiny, many debt-laden companies were bid up as investors concluded balance sheet strength was a concern for another day. This approach is short-sighted, in our view, given the unprecedented levels of corporate debt—estimated at more than $3 trillion—that will need to be refinanced in the next few years.

The march higher took on a familiar feel as larger names continued to outpace smaller. The pull of large companies has become so strong that, as shown [below] [to the right], the 10 largest companies in the S&P 500 have a combined market cap of MORE THAN 3X THE ENTIRE RUSSELL 2000® INDEX of small companies. This type of stampede into pricey mega-caps has historically ended poorly for those who followed the crowd.
 
Capped out?
Small-Cap to Large-Cap Historical P/E Ratio
Source: Furey Research Partners, LLC,  Standard & Poor’s, and Russell®, 12/1/1985 to 12/31/2019. This chart shows the aggregate market cap for the ten largest
companies in the S&P 500 Index divided by the total market cap of the Russell 2000® Index.
Past performance does not guarantee future results.
 
No room for error?
Despite mixed economic data and extreme corporate debt levels, we would not be surprised to see the markets surge higher in the near-term as investors who were sitting on the sidelines jump back into equities out of fear of missing out on the next big rally. Yet we believe the recent runup in valuations has reduced the margin for error in today’s markets.

A slow and steady trajectory for the economy could amplify the differences between high-quality businesses with a clear, achievable path to improvement from those that have binged on debt in an attempt to evade a future day of reckoning. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.

Sincerely,
Your Heartland Team

 

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