Low Quality Playbook, Ripped Off Band-Aids In Small Cap - Transcript

Welcome to RBC’s Markets in Motion podcast, recorded August 15th, 2022. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.

Today in the podcast, a few thoughts on the composition of the snap back in stocks, where the earnings band-aid may have been ripped off within Small Cap, and the thing that caught our eye in last week’s University of Michigan consumer sentiment survey.

Three big things you need to know: First, low quality has started to work within Large Cap, something that’s frustrating investors, but began for Small Cap in June and typically happens after stocks have found their mid recession bottom. Second, we’ve been getting asked by Small Cap investors about where earnings sentiment has been most depressed within the Russell 2000 – similar to Large Cap it’s a number of key consumer/Tech/cyclical groups. Third, what jumped out most in terms of our sentiment indicators last week is that consumers of all political affiliations are feeling a little bit better in August, helping consumer sentiment stabilize a bit in the University of Michigan survey.

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Now, the details.

Takeaway #1: Low quality is starting to work within Large Cap.

  • Last week we got an earful about how frustrated investors are with the snapback in stocks and the composition of the rally.
  • Our charts of the week highlight how the low quality trade – low ROE, negative earners, and highly shorted names – has recently and suddenly started to outperform within the Russell 1000 after an extended period in which the higher quality versions of these factors were in the drivers seat.
  • While we understand the frustration that many investors feel, since few active managers like to market themselves as stewards of low quality stocks, we think it’s important to remember two things.
    • First, while high quality tends to outperform over time, low quality tends to outperform coming out of recessions within Large Cap.
    • Second, a low quality bias to performance already started within Small Cap in June. What’s happening in Large cap is a broadening, not a beginning.
  • While we have a great deal of sympathy for the pain many institutional investors are feeling, the fact that this tenet of the historical recession recovery playbook is playing out leaves us feeling more confident that mid June may end up being the market low. What’s playing out now is simply what happens after markets make their mid recession low.

Moving on to takeaway #2: In terms of top questions, we’ve been getting asked by Small Cap investors about where earnings sentiment has been most depressed within the Russell 2000 – similar to what we are seeing in Large Cap it’s been a number of key consumer/Tech/cyclical groups.

  • Last week the charts that were catching the most attention in our meetings and calls highlighted which industries within the Russell 1000 (Large Cap) universe have looked most beaten up on the rate of upward EPS estimate revisions.
  • As a reminder, this is a stat we watch closely for the broader US equity market and is something we view as an important gauge of earnings sentiment. At ~30% recently, in line with non Tech bubble/GFC/pandemic lows, it’s been telling us that earnings sentiment has been hit quite hard even though the downward revision in dollar terms has seemed rather mild.
  • The list of Large Cap industries that look the most washed out on this metric, i.e. those where one can argue that the earnings “band-aid” may have been ripped off, has included things like Metals & Mining, Semis, Household Durables, Specialty Retail, Interactive Media & Services, and Internet Retail. There’s a list of about 11 groups in total we’ve been highlighting.
  • Our Small Cap clients have been asking us what groups in the Russell 2000 fit this criteria. The list is similar to what we see in Large Cap, with representation from Tech/Consumer/and Cyclicals. But the list in Small Cap is a bit longer. It includes things like Internet Retail, Semis, and Specialty Retail, as well as things like Airlines, Hotels Restaurants & Leisure, Auto Components, Consumer Finance, Leisure, and Machinery.
  • Note that we aren’t making fundamental calls on any of these groups. We’ll leave that to our analysts. What we are saying is that from a quant perspective, investors looking for deep value/contrarian opportunities or those in which the most negativity has been baked in from an earnings perspective can use these groups as a starting point for further analysis.

Wrapping up with takeaway #3: Consumers of all political affiliations were feeling better in August and signs of recovery continued in our sentiment barometers last week.

  • On Friday, the University of Michigan consumer sentiment survey came out. We’ve been keeping a close eye on how consumers with different political affiliations have been feeling since Republicans have been feeling much worse than Democrats in this survey, and the mid terms are coming up later this year.
  • What caught our eye was that consumers of all political affiliations – Republicans, Democrats, and Independents – have seen sentiment stabilize a bit.
  • This broad based improvement makes sense to us given the decline in gas prices we’ve seen recently, which has occurred alongside some modest stabilization in Biden’s approval numbers.
  • The modest but broad recovery in the Michigan data echoes what we are seeing in the investor sentiment indicators that we track - the AAII retail investor survey, CFTC’s data on asset managers’ futures positioning, bitcoin, the equity put call ratio…
  • …and the VIX. Modest signs of healing, after extreme pessimism emerged, are starting to be seen, in all of these in recent weeks.
  • Although the S&P 500 ended last week a little above our 4,200 target, and we remain concerned about the potential for some renewed volatility in the months ahead due to EPS expectations that still seem too high in Dollar terms and building uncertainty about the midterms, on balance we ended the 2nd week of August feeling like we still belong in the constructive camp on stocks.

That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s Industries in Motion, for thoughts on specific sectors from RBC’s team of industry analysts.