Rally Diagnosis: Acute Monetary Fever
By River Road Asset Management, Subadviser to Aston Asset Management
(The following article is an excerpt from the second quarter 2013 commentary for the ASTON/River Road Small Cap Value Fund.)
At the beginning of 2013, our outlook for small-cap stocks was for mid-to-high single-digit returns based on valuation and the assumption of modest stock-price multiple expansion. The assumption of modest multiple expansion is where we got it wrong—at least thus far. Year-to-date through July 15, small-cap stocks (as represented by the Russell 2000 Index) have soared nearly 24% as the forward multiple on stocks have skyrocketed. According to Bloomberg, the forward price/earnings ratio on the Russell 2000 rose from 18 times earnings on Dec 31, 2012 to 22.5 times by June 30, 2013. The higher quality S&P 600 Index rose from 16.6x to 19.4x.
It is difficult to explain logically the rise in multiples using fundamental company analysis. Earnings growth for small-caps is tepid, and in the broader economy anemic. In addition, the economy appears to be in the late stage of its current profit cycle, with expectations on both the economic and profit fronts declining. Forward earnings guidance from company management teams has been overwhelmingly negative recently, and we do not expect a material change during the upcoming reporting season.
There have been a few economic bright spots, most notably housing. New and existing home sales, as well as home prices, have experienced significant growth during 2013. That growth is supporting small-cap performance. Of course, with interest rates rising sharply over the past two months, mortgage and refinance applications have dropped, as have the stocks of home builders. Although we recognize that volatility, credit spreads, inflation, and interest rates (all of the factors that can work against small-cap performance) are still below their long-term averages, at current valuations it is hard to believe (from a fundamental perspective) that stocks should continue to go up. Yet, the rally persists.
What is driving stock prices? The best answer we can think of is acute monetary fever. Monetary fever is caused when central banks flood markets with excessive liquidity. Initially, excess liquidity can prove helpful in stabilizing financial markets and raising asset values (the first two instances of quantitative easing, QE, by the US Federal Reserve). When intrinsic value is reached, however, and the liquidity continues to flow (as with the current easing program, QE3), bubbles begin to form. Today, we see bubbles beginning to form across a wide range of asset classes.
Acute monetary fever happens when investors appear to lose any sense that policy will ultimately change or asset values are illogical. This appears to have happened with the surge in stocks over the past few weeks, with any economic news (good or bad) now being positive for stocks. This represents a complete disconnect from fundamental reality. We saw a similar liquidity event followed by a disconnect during the late stages of the Internet bubble (remember Y2K) and in the late stages of the consumer credit/housing bubble (no money down, teaser loans). QE3 may be remembered in the same context. Cheap money always feels good in the moment (at least for those invested in anything other than CDs), but every bubble ends with a burst.
Precisely when the monetary fever will break is impossible to say. The Fed and other central banks have proven remarkably committed to inflating financial assets. It is possible that the Fed will unwind its current policy in an orderly fashion—that rates will slowly rise and asset values will gradually move back toward their intrinsic value. Unfortunately, history and our collective investing experience do not support that probability.
Then again, the Fed’s statement on June 19 may have been intended to let some of the air out of the bond bubble. If that is the case, it worked. Bond funds and, in particular, high-yield bond funds have seen record redemptions. Of course, these funds are now flowing into stocks. According to Furey Research Partners, the $80 billion differential between stock and bond flows the past six weeks represents the first major reversal of the longer-term trend favoring bonds in more than five years. Back in December 2012, we stated that a lottery ticket existed for stock investors in the form of the government bond market bubble. Perhaps stock investors have hit the jackpot.
The information contained in this article is provided by River Road Asset Management (“River Road”), a subadviser engaged by Aston Asset Management, LP (“Aston”). River Road is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and River Road’s views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends, and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
Before investing, carefully consider the Fund’s investment objectives, risks, charges and expenses. Contact (800) 992-8151 for a prospectus or a summary prospectus containing this and other information. Read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.