The third quarter was a rocky one for small and mid-caps. Performance started out on a positive note, as once again earnings reports were mostly better than expected. As the quarter wore on several concerns weighed on stocks, and while there were some gyrations the overall direction was south. A mélange of factors pushed stocks lower, with higher energy prices and rising interest rates leading the charge. These headwinds were fueled by better-than-expected macro data and the still hawkish Fed. But there were micro drivers as well. Healthcare was the worst performing sector, and as best we can tell the negative performance was driven by the “Covid hangover,” high multiples, and concerns over funding for biotech research and drug development. The Covid hangover refers to the idea that many companies in the sector benefitted from copious funding during the pandemic, which led to unsustainable revenue growth. The companies tried to tease out the covid-specific boost, but in many cases it turned out to have been even more pronounced than estimated. Adding to the pain many companies in the sector are not self-funding and rely on external financing - cash burn has become a focus. Slower growth coupled with tighter financing markets resulted in a reset, and the stocks suffered. At the other end of the performance spectrum Energy ripped, advancing 17% for the quarter. Better current macro growth combined with compressed valuations powered the stocks higher. Fleeting as it often is, we’ve already seen the bloom come off the energy rose early in the fourth quarter as growth have reemerged. Healthcare’s weighting is more than twice that of Energy in the Russell 2500, so the strong Energy performance only dented the negative pull of Healthcare. Away from these two sectors Financials eked out a tiny gain, and all other sectors were down. Energy’s rally was driven by higher commodity prices, effectively a tax on the rest of the economy, so it’s not surprising that most stocks struggled.
Russell 2500 Index Healthcare (Yellow) vs. Energy (White)
The other major drag on small and mid-caps (along with most stocks) was obvious to even a casual market observer:interest rates. Powell & Co. have made their intentions clear (higher for longer) but as always Mr. Market weighed too, organically pushing rates higher. Several factors beyond the Fed are at play, with better-than-expected current economic conditions (and the possibility of further strengthening) being the most obvious driver. On top of that a challenging supply/demand picture for government debt has emerged. Some of the usual treasury buyers have less appetite, lowering overall demand. On the supply side big spending plus ballooning deficits leaves Uncle Sam looking to issue a large amount of debt.
Treasury auction sizes will in 2024 increase on average 23% across the yield curve.
This market action may help the Fed by tightening financial conditions, but potentially causes problems down the road. The odds of “something breaking” are increasing, leading to investor consternation.
US Generic Government 10 Year Yield
It’s fair to say the third quarter market backdrop was mixed. SMCO fared relatively well, declining -2.44% gross/-2.61% net compared to a -4.78% drop in the Russell 2500. We saw decent contributions from our Industrial, Energy and Staples holdings. Alas we weren’t immune to the sell-off, with Healthcare, Communication Services and Utilities detracting from performance. The relative picture, where we bested the index, was a little different. Our Industrial holdings were even stronger on a relative basis, and we enjoyed positive relative performance in Healthcare and Consumer Discretion where our holdings were down less than the index constituents. Our worst relative performance came from Communication Services, Energy and Utilities. We saw greater negative contribution in Communication Services and Utilities, and our Energy holdings contributed less to our total return than what the sector contributed to index returns. This leaves SMCO still a little behind year-to-date, up 3.11% gross/2.56% net vs. the Russell 2500 up 3.59%, but on a longer-term basis our returns compare favorably to the index:for the one year period SMCO is up 16.45% gross/15.60% net versus 11.28% for the Russell 2500, and inception-to-date (2/1/2019) SMCO’s annualized return is 9.82% gross/9.07% net vs. 7.05% for the Russell 2500.
Trading activity in the quarter was light, with turnover running just over 3%. Most of our moves were incremental adds or trims, but we did add three new names to the portfolio, one in Financials, one in Technology and one in Real Estate. The tech name is an orphaned spinout where we see an interesting, undiscovered story. In the near term the company will see shrinking revenues, but we see an intriguing picture of improving margins followed by eventual revenue growth. The Financial name and REIT we purchased are for very company specific reasons, and while both are down slightly from initial purchase we see good long-term prospects. In these cases compressed valuations, driven by industry concerns, presented what we see as opportunities to pick up good companies at a discount to their valuation histories.
The road ahead is anything but clear. The still restrictive Fed and the continuing ascent of interest rates have kept investors uneasy. Can higher rates blunt inflation without pushing the economy into recession?Will giant government deficits lead to unintended problems? Can corporate earnings growth actually recover, as is currently projected, in the fourth quarter?Many questions, each with significant implications. As such we remain cautious, and exposed to areas such as infrastructure, environmental services, energy modernization & transition and cybersecurity where funding is visible. From a positioning perspective we’re still well overweight Industrials, Technology and Staples. Our most pronounced underweights are in Financials and Consumer Discretionary, areas where we perceive underappreciated challenges. Pronounced economic uncertainty makes company specifics all the more important. Many babies are being are being tossed out with the bathwater, and our task is to identify them. We strive to be diversified, and when conditions are this opaque the ability to identify good companies, regardless of sector, can reap significant rewards, both absolute and relative.
Earnings season will start soon, and it could prove pivotal. The recent stock market weakness creates a less demanding setup, but the expected upturn in earnings growth must materialize for stocks to move higher. Given the current environment we see the expected acceleration as challenging. We’ve been tilted defensive, and for much of the year that has proven to be a hinderance. To be blunt we were wrong and lagged our index for most of the year. More recently our stance has become an asset, and for now we see it as prudent. If a reset is coming it would not be unusual for small and mid-cap stocks to lead us out once it occurs. In the meantime our risk-aware approach, and attention to downside risk, could prove advantageous if the market stays roiled.
So, what’s with the cryptic title?Those who have read this far have earned the right to know. October 15th will be the 50th anniversary of the release of the Grateful Dead album Wake of the Flood. Since I am a complete music geek I preordered the limited edition “watermark” vinyl version of the album, and was excited to play it when it arrived. The album’s title is the opening line of the song “Here Comes Sunshine”, a bright, uplifting track about the sun shining through after, obviously, the flood. As I listened to the track it occurred to me that it serves as an apt analogy for the bullish view entering the 4th quarter – we’ve been through a lot, and the economy indeed may stay resilient. There’s bright sunshine ahead. But the data and indicators are, in my opinion, more mixed than that. There are several unresolved problems, and usually reliable indicators are flashing bright red, suggesting a recession is still in the offing. Mulling over this less rosy set of considerations, and sticking with the flood theme, another classic, from a very different band, popped into my head:Led Zeppelin’s “When the Levee Breaks. ” This song’s more foreboding tone might better capture where markets stand. “If it keeps on raining the levee’s goin’ to break…”It’s possible that those usually reliable recession indicators aren’t wrong, but the timeline has stretched due to the distortions caused by pandemic/post-pandemic peculiarities. We look forward to the sun emerging, but we think it prudent to keep a wary eye on the levee. And maybe stick to higher ground, at least for now. Just to be careful.
As always, we remain vigilant and stand ready to move the portfolio more dramatically if conditions dictate. That could take the form of stock-by-stock changes, or by sector and industry related moves.