Go west for historic returns: Favourable fiscal policies see US hit all-time highs

In the past few months, we have reached an extraordinary turning point in markets – a turn for the ages and the history books. It presents an investment opportunity, the like of which many of us have not seen in our lifetime and which many of us will not see again.

The turn is occasioned by the reverse in the interest rate cycle repositioning itself back to where it was at the end of the Second World War, after 40 years of falling rates. 

The implication of this change is that investors should reposition themselves in long-term outperforming parts of the market.

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However, the problem is these sectors have been out of favour for so long that many participants today do not even know the names of the stocks, let alone remember when they were the place to be.  

The long-term evidence leads us to now gather in US small-cap value.

Why the US?

Firstly, then, why should we go to the US, when it is already 55.9% of the global market and at an all-time high?

The answer is simply that it has been, and remains, the best performing major market according to research from a number of leading economists: Dimson, Marsh, Staunton et al.

Let's not dwell on it. The reason is also simple. Rule of law and corporate governance correlate with stockmarket returns.

Why small?

Having landed in the US, why should we go small? The answer is that they work - evidenced by small having outperformed large stocks, government bonds, treasury bills and inflation over nearly 100 years between 1926 and 2017.

Small stocks outperformed in the rising interest rate environment following WWII. After nearly 40 years, they peak in 1983 and their outperformance is closely tied to the interest rate cycle. They outperform when rates are rising because both are indicative of a decent economy.

In low-growth periods of falling rates, small may jog along just a bit better than the market. In periods of low growth and very low interest rates, small underperforms as happened from 1926 to 1938 and also in the current century.

Why value?

Moving on, the prime predictor of outperformance is value. It dwarfs the two previously discussed heroes - the US and small companies - as according to data from Dartmouth, it has outperformed growth by a factor of 17 since 1927.

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A surprise, then, that this wonderful asset class has underperformed worldwide since 2004. In the US after the Global Financial Crisis, value went from 100 to 320 while growth went from 100 to 550, and although this deficit looks dramatic, it will shortly be made up when value gets going again. 

Cognitive dissonance is the reason why value outperforms. Not only do value stocks tend to improve more quickly than expected, they can also sometimes turn around and be re-rated as growth stocks again.

When reversion occurs, all the precise discounted cashflow valuation methods, which give the analysts their ever so precise target prices, fly straight out of the window.  

The problem is that stockmarket price discovery is through humans buying and selling. As humans, we have evolved to see sabre-toothed tigers hiding in the long grass, patterns in the sky which we call astrology and patterns in the stock charts which we call Japanese candlesticks.

We place too much weight on our abilities to extrapolate into the future and then change the narrative to maintain our self-esteem in a dangerous world when we are wrong.

Why now?

Having established what wins, why now? All is explained by interest rates. This has been the biggest cycle.

The all-time peak was in 1981 when Paul Volcker, the Federal Reserve chair between 1979 and 1987, determined to beat inflation at any cost to employment and put short-term rates up to 20%, ushering in 40 years of monetary policy.

Interest rates bottomed in 2020 with a third of sovereign debt guaranteeing you a negative return if you held it. A massive all-time low.

They turned when current US President Joe Biden determined to beat unemployment at any cost to inflation, ushering in a return to fiscal policy.

The small and value parts of the US market are starting to outperform again having reached their worst position relative to growth and large caps since 1904. After this greatest of cycles, the elastic band is stretched to historic levels.

When you think that the amazing changes to technology make it different this time, remember that their valuation rises have been created by putting lower interest rates in the models and at 0% you can get an infinite valuation and never have to make profits at all.

Remember, too, that monopoly policy catches up in the end. John D. Rockefeller's outperforming large-cap Standard Oil controlled 91% of US oil production and 85% of oil sales, its peak. In 1911, it was broken up. 

Richard de Lisle is manager of the VT De Lisle America fund