The Three Types of Lies

Posted in: Economics, General, Stock Market, Thought of the Week

Mark Twain once said, “There are three kinds of lies: lies, damned lies, and statistics.” This famous quote is a reminder that although statistics are powerful tools to help us recognize relationships, it’s far more important to understand the drivers of a relationship in order to profit in the future. Investors often succumb to the dangers within statistics because they carry powerful psychological triggers. It is human nature to believe statistics on face value. However, we must do more than just observe a relationship in order to prevent losses and maintain low risk levels.

Lately there has been an extraordinary amount of talk about the Russell 2000, which is an equity index that represents small-cap stocks totaling close to 10% of the total U.S. market capitalization. Investors often use the Russell 2000 as a barometer for investors’ risk appetites because these investments typically offer shareholders a higher growth rate than larger companies. When bulls are rampant in the market, the Russell 2000 seems to lead the charge. In 2013, the Russell 2000 had a return of 36.8%. However, since the start of 2014, the Russell 2000 has lost about 5%, and down 10% from its peak. Wall Street tends to label a move greater than 10% down as a “correction”. The interesting part is that this correction is usually accompanied by large-caps falling around 13%, until now. Simply put, this seemingly obvious relationship predicated upon historical statistics appears to have broken down.

Our Investment Committee has done the work to deduct the real reason why small-cap stocks are correcting and large-caps are not. They believe that investors have started to pay attention to valuation. Small-cap stocks flew too high too fast, and investors became nervous holding many stocks that trade at meteoric valuations with little to no earnings. Large-cap stocks are nowhere near as expensive. Our Investment Committee believes that large-caps are trading in a range that seems to be fairly valued. Our Investment Committee continues to be opportunistic and wait for cheap stocks to emerge that can offer attractive returns for our investors.

In summary, our Investment Committee will continue to keep a close eye on valuation because they are thinking for the long-term. Their goal is to manage downside by looking for quality/misunderstood stocks with valuations that are so low that it creates an implicit floor in the stock price. Remember, large-cap stocks don’t simply follow small-cap stocks blindly. Large-cap stocks continue to show strength because their valuations are lower and the economic data continue to point to a slowly growing economy.

Read this week’s Thought of the Week to learn more about the role of small-cap stocks in the market.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.