 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
|
 |
Mid-Year Market Analysis
Between February 1, 2000 and March 31, 2005, the Standard & Poor’s Small Cap and Mid-Cap Indices significantly outperformed the broad market, as measured by the Standard & Poor’s 500 Index, and the large cap sector, as measured by the Russell Top 200 Index (see chart at right). New data points to changes ahead. Currently, however, we believe a significant shift is imminent. We have seen evidence that investors are moving to higher-quality investments in order to: • Reduce risk; Bond market indicates a “flight to quality” An excellent measure of investor preference for assuming investment risk is the “spread” between the yield on “BB-rated” industrial bonds and the yield on 10-year U.S. Treasury Notes. If the “spread,” or difference, between these yields is narrow, it means the market is not that concerned about risk. If it is wide, the market is concerned about risk. Over the past 15 years, the mean yield spread has been 352 basis points (3.52%). In the fall of 2002 (see point A on chart below), the most-pessimistic spread of 700 basis points (7%) was registered — the widest spread in over 15 years. This signified an extreme aversion to — or concern about — risk. In February 2005 (see point B on chart), a highly optimistic spread of only 190 basis points (1.9%) was registered — the narrowest spread in over 15 years. This signified very little concern about risk. Recently, the spread widened within a very short time (see point C on chart) to 355 basis points (3.55%).
This sharp reversal is a clear warning sign that investors are becoming less willing to incur investment risk and are shifting their preference to higher-quality investment instruments. The market capitalization “case” How might these risk trends be reflected in the stock market? Logic would conclude that investors would turn to stocks of larger, less-risky companies. They might also seek out not just large companies, but the highest quality, large companies, in order to reduce their investment risk. As a result, since April 1st, we believe an opportunity in large-cap stocks has emerged. It is important to note: opportunity is not driven only by a “flight to quality,” but also by the fact that attractive relative value exists in high-quality, large-cap stocks.
As of June 17th, large company stocks showed the lowest absolute trailing price/earnings ratio (17.0 times earnings) and the best upside opportunity (21%), when compared to mid-sized and smaller companies. This strongly suggests the valuation advantage has shifted in favor of large-cap companies (see chart below). The high-quality “case” The opportunity that exists in the high-quality sector of the market is evident in the valuation spread between top-quality and low-quality stocks. Using the S&P quality ratings, we ranked the stocks by quality and calculated the average P/E ratio of the top 20% and the bottom 20% of the S&P 500 (“the market”) and the Russell Top 200 (the largest cap companies).
Using either index, the top quality stocks are selling at a 34% to 36% discount from the lowest quality stocks (see chart below). Our conclusion The Partners of Midwest Investment Management would welcome a long-term market shift to large-cap, high-quality stocks. We believe such an occurrence would create a timely opportunity for our style of investment management and, most importantly,our clients. If you are not a Midwest Investment Management client, now may be an ideal time to move your portfolio to our firm. The anticipated market shift, combined with the insight and experience of our analysts and portfolio managers, may produce attractive, long-term results.
|
