Put Me In, Coach

Everybody loves an underdog, right? Or that player who sat the bench all season, who comes in during the playoffs, and has the game of their life? I know I do. Sometimes markets do too, but betting on the underdog involves more than just luck or chance.

That’s the difference between investing and sports: Athletes may have a single play that defines their whole season, or a game that defines their career.But in investing, we’re looking for more frequent and repeatable wins. Let’s look at some current market underdogs and decide if it’s a good time to place a bet.

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Small, but Mighty

The saying “how I cut my teeth” is often used when talking about the early days of someone’s career, referring to the job or the environment where the person first started learning about an industry.

I usually refer to small-cap stocks as a big part of how I cut my teeth. It was the first asset class I wanted to cover, and the one that taught me about portfolio management, and how company fundamentals line up (or don’t) with economic fundamentals. And it was full of company names I’d never heard of, in a market that was less efficient than large-caps and ripe for mispricings. That was exciting to me as a 20-something, and still is today, although my risk appetite is certainly lower in my 40s.

Despite my affinity for small-caps, my philosophical belief that they can offer outsized opportunities, and that they are one of the pillars of the American Dream, even I can admit they’re not always a good buy.

This year has seen major underperformance of small-caps relative to large-caps, leading some to believe that small-caps are due for their moment in the spotlight, and offer attractive relative valuations. While the valuation argument may be true in certain sectors, the idea that small-caps are “due” could be a bit premature.

There have been a couple head fakes this year already: In January the Russell 2000 returned 9.7% while the S&P 500 only returned 6.2%. And from the beginning of June through the end of July the Russell 2000 put up a 14.5% return while the S&P 500 put up 9.8%. Both periods drove market participants to shift their narrative to small-caps keeping up, and sending a pro-cyclical signal.

But in the whole year to date, the S&P 500 is still outperforming the Russell 2000 by 14 percentage points, with the Russell negative on the year and the S&P in double-digit positive territory. How could small-caps have such strong bursts of outperformance yet be trailing by so much over a longer horizon? Because the economic cycle hasn’t supported them yet, and we must respect the cycle.

I want small-caps to come back, too, but they tend to see their best relative performance as the unemployment rate is rising at a fast pace, and that’s not the situation we’re currently in. Not only that, but it’s typically when they start a sustainable period of outperformance versus large-caps.

The fact that the labor market has shown such resiliency is a proof point as to why small-caps have tried to rise from the ashes but failed more than once this year. The unemployment rate rises in slowdowns and recessions, just after “late cycle,” and just before we begin “early cycle.” Right now, most economic indicators are still flashing “late cycle”, and that’s also the case with market signals when we compare them to the performance patterns below:

There are clear rotations that are typical of the pre-, during, and post-recession periods. For stocks, large-caps tend to outperform before and during, but trail small-caps after. Long-term government bonds show a clear pattern as well, and it’s one worth noting especially during a time when investors have been pummeled by rising yields and falling prices, with the long-term Treasury ETF (ticker TLT) down more than 15% this year.

Most naysayers will tell you Treasuries won’t protect you in a downturn because this is a new era, and rates have to stay high even if the economy slows. But I’m not one of those naysayers; I think Treasuries can rally across the curve in the event of a negative shock or recessionary environment.

Still unknown though is whether or not we’ll actually have a recessionary environment any time soon.

From the Bench

The last form of underdog I’ll cover this week is to be found in sectors. We frequently talk about sector weights in the index and how much impact, or lack thereof, they can have on broad returns. As the Q3 earnings season heats up, it’s interesting to look at the earnings weight each sector has as compared to its market-cap weight. The biggest dispersions are in Energy, Financials, and Tech.

We’ve become accustomed to Tech leading the pack, and it still does so in both categories of weightings, but the chart above shows how much more of an influence Tech has on returns than on earnings.

The underdogs with big dispersions in these weights are Energy and Financials. Both punching above their weight on earnings, but not packing as much of a punch on index returns. That’s ok when the two aren’t performing well, but if there is a market rotation as we move through the business cycle back to early phase expansion, I would expect these underdog sectors to perk up, much like small-caps.

This illustrates how sometimes the earnings headlines don’t line up with index performance, and the market may seem like it’s not trading on fundamentals. On the contrary, the market may be trading on fundamentals, the activity is just masked by sector weights that overpower those moves.

In my opinion, we are still in the late part of the cycle, pre-contraction, and even more pre-early cycle. As we move through the phases, market performance is likely going to change, and some of these dispersions may narrow, or even invert. The moral of the story remains: respect the cycle, and rely on logic, not chance.

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

Communication of SoFi Wealth LLC an SEC Registered Investment Adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at adviserinfo.sec.gov. Liz Young is a Registered Representative of SoFi Securities and Investment Advisor Representative of SoFi Wealth. Her ADV 2B is available at sofi.