Yardeni: Small-Cap Exodus Won’t Stall S&P 500

September 30, 2014

Ed Yardeni is president and founder of Yardeni Research, a global investment research strategy firm. A former economist for the Federal Reserve Bank of New York, he is widely followed by institutional investors for his investment strategy publications. Dr. Yardeni is often seen on CNBC and is published in financial publications like the Wall Street Journal, New York Times and Barron's.

Dr. Yardeni recently sat down with ETF.com to discuss why small-caps are underperforming large-caps and compares valuations between different markets. He tells us why he prefers corporate bonds over Treasurys and why the U.S. dollar is likely to remain strong in the coming year.

ETF.com: The S&P 500 has now hit your year-end target number of 2014, with three months left in the year. Do you have a new target now?
Ed Yardeni: I had the same "problem" last year, when my year-end target for 2013, which was 1,665, was hit in September. In September of last year, rather than tweak the year-end forecast, we started talking about a target of 2014 in the year 2014. It's close enough to year-end that I didn't really see much point in fine-tuning the forecast. So now, that's sort of a repeat. We've got our target achieved here, so we're now talking about next year. I'm going to leave my year-end target the same.

We can just stumble around here for the rest of the year, since I think the market needs to consolidate a little bit. In addition, we're seeing some internal correcting, and internal correction in the market, which has been going on all year, with investors moving out of high P/E stocks into lower P/E stocks, so that they're mostly moving out of small-cap into larger-caps. So next year, we're thinking of 2,300 for the S&P 500 before the end of next year.

ETF.com: You mentioned investors rotating out of small-caps into large-caps. In an interesting twist, small-caps have underperformed large-caps since spring. Some investors view small-caps as a leading indicator. Does that concern you at all?
Yardeni: You have to be concerned because there have been precedents for this. It's not a happy signal, obviously. It's better to see a bull market broadening than narrowing. But I guess the concern would be that if it's not just an internal correction, but it's a signal that the recession is coming, that would be something to worry about. Typically, in the business cycle context, small-cap stocks perform very badly in recessions.

But I don't think the weakness of the small-caps reflects investors' concerns that a recession is coming in the U.S. It's kind of a reaction to last year. Last year these small-caps had an extraordinary outperformance. They're just getting back some of the gains. But, rather than moving out of the market, I see investors moving towards cheaper stocks, and most of them tend to be larger-caps.

ETF.com: Three months ago, you preferred defensive sectors, such as health care and utilities. Do you still favor "defensive" sectors? Or do you like cyclical sectors right now?
Yardeni: These days, the old definitions of what is cyclical and what is defensive needs to be amended. Health care has actually become a very aggressive play, especially when you look at biotechs and health care technology. There's quite a bit of technology these days in health care. They've done well. So I still like them.

Utilities have been an odd sector this year because the gas utilities have done extremely well. That's really been more a play on the cost of energy, rather than a play on the bond market. Though clearly, utilities have done well, in part because bond yields have done the opposite of what most people thought, that those yields would come down.

At this point, I would stay with health care. I would get a little bit more cyclical with industrials, which have underperformed, and in prevention technology, which has done well, but I think should continue to do well. Financials are appealing, mostly because they're cheap. If investors are looking for relatively low P/Es, they're in financials. Financials have substantively been a market performer. But they could be an outperformer if the U.S. economy continues to grow reasonably well.

ETF.com: You raised an interesting point that it's tough to find a defensive sector now. So how do you get defensive?
Yardeni: The focus would have to be in blue-chip, large-cap stocks. They're not cheap, but they're certainly cheaper than small-caps, midcaps. If you're looking at this on a valuation basis globally, emerging markets are still relatively cheap compared to some U.S. valuations. But you really have to know what you're doing, or just buy a broad ETF. The global economy is likely to continue to grow.

A lot of emerging economies are becoming less dependent on exporting commodities of labor-intensive products as their domestic markets are growing. I don't think it's so much a question of defensive versus cyclical. The big question is valuation. On a relative basis, the cheapest stocks are in the emerging economies, selling on a multiple around 11½. On the other hand, you could pay something like 15½ P/Es for U.S. large-caps. So they are more expensive. But compared to small/midcaps, they are still pretty cheap.

If you want to get really defensive, then you wind up being in the short end of the bond market or in the money markets. But preserving your capital is not going to give you any significant return.

ETF.com: Let's talk about fixed income. How are you advocating investing in fixed income, looking ahead in 2015?
Yardeni: My advice has been that if you bought the bonds right, don't sell them. My view is we're going to have 10-year Treasurys trading between 2.5 and 3 percent for the end of this year, and well into next year. If the Fed does tighten, we'll probably see 3 percent on the bonds, and I think could pretty quickly have an adverse effect on some areas of the economy like the housing market.

But I don't see an inflation problem. I see the U.S. economy growing moderately, with the overseas economy remaining very weak. What makes U.S. bonds look still attractive is in comparison to yields in Japan and Germany, where yields are 1 percent or less.

As long as the global economy continues to look weak, anybody who bought bonds right with a good coupon should just clip the coupon and relax.

ETF.com: In our previous conversations, you preferred corporates over Treasurys. Does that still hold true?
Yardeni: That still makes sense. It's not a hard conviction. In other words, I think you'd do well in both. But if you're buying bonds now, it's better to buy the corporates. I recognize that the main disadvantage of corporates is they're not as liquid as Treasurys. But if you're going to buy them, you've got to be happy with the coupon and stick with it, because if in fact we ever do get a significant backup in bond yields, it could be very difficult to sell the corporates.

To the extent liquidity is an important issue, then Treasurys are actually a better place to be because if you do want to get out, you'll be able to get out fairly quickly. While in corporates, it's going to be much tougher.

ETF.com: The other sector where investors have been reaching for yield is REITs. In 2014, in a surprise twist, REIT ETFs have surged in performance and assets. Do you like REITs, or do you see some risk here?
Yardeni: REITs are OK. I don't really feel strongly one way or another about them. They've had a good run. They do well when bond yields come down, or bond yields stabilize. They stabilize, and you just get your return on them. They're still a reasonable place, but don't expect any big gains on them.

ETF.com: You predicted in March that the U.S. dollar would strengthen this year. In recent months, the dollar has really surged against a broad basket of currencies. Do you see that continuing into next year?
Yardeni: I do. The U.S. economy is likely to outperform many other major economies like Japan and the eurozone. So that's favorable for the dollar. One of the reasons it will favor the dollar is because foreigners will continue to pile into our bond and stock markets. A stronger dollar would be a negative for commodities for prices.

So shorting commodities, or certainly not being long, would be my scenario. I think gold will continue to underperform. The price of oil may continue to go lower, which would be a big benefit to the U.S. economy, particularly consumer-related stocks and of course, any transportation stocks.

ETF.com: A lot of currency-hedged ETFs are starting to take off, especially in this rising-dollar scenario. Do you have an opinion on currency -hedging for investors looking to invest overseas?
Yardeni: The problem with having unhedged positions is that you're really taking two bets. Investing is a tough game to start with, and trying to also judge the currency where it goes can be pretty tough. If the dollar is going to be stronger, if my forecast is correct, then you want to be hedged.

ETF.com: Thanks for your time.

ETF.com INSIGHT

WisdomTree Bloomberg US Dollar Bullish (USDU | 67)

Yardeni has been calling for a stronger dollar since early 2014. He believes the trend will continue from foreigners "piling" into U.S. bonds and stocks. If you're on board with his contention, USDU provides solid "long-dollar" exposure against a basket of global currencies. Unlike the decades-old US Dollar Index, which is more than 60 percent weighted in the euro, USDU is a trade- and liquidity-weighted fund that provides short exposure to 10 different currencies, including the Australian dollar and some emerging market currencies. The euro and Japanese yen, combined, currently make up about 50 percent of the fund's weighting. Since its launch in December 2013, USDU has amassed more than $55 million in assets. Its $100,000 median daily volume is not much, but USDU has robust block liquidity. Spreads still average 12 bps, so limit orders are recommended.

Schwab Fundamental U.S. Large Company (FNDX | A-87)

Citing steep valuations on mid- and small-cap stocks, Yardeni sees "investors moving towards cheaper stocks" and points out that "most of them tend to be larger-caps." There are more than 50 broad-based U.S. large-cap ETFs to choose from, but one that fits Yardeni's valuation focus neatly is FNDX. The fund uses balance sheet metrics such as sales, cash flow, dividends and buybacks to select and weight its portfolio of more than 600 holdings. FNDX's expansive portfolio has an aggregate P/E near 18 compared with the steeper P/E's of 25 and 40 for mid- and small-caps, respectively. As investors have shifted toward large-caps, FNDX has returned close to 20 percent over the past year compared with 15 percent for midcaps and 11 percent for small-caps.

ETF.com Alpha Think Tank ETF Tracker

Methodology: ETF selections are made solely by ETF.com. They are neither selected by, nor are they investment recommendations from, Alpha Think Tank strategists. ETF selections are made by the ETF.com Analytics team based on the themes highlighted in each weekly interview with Alpha Think Tank strategists.

We implement a stop-loss of 10% from the ETF.com Pick Date, whereby any funds triggered by that stop will drop off the tracker. The tracker data is updated weekly and is subject to change, according to our ongoing interviews with our strategists.

Ticker Fund Name ETF.com Pick Date TR % (Since Pick Date) TR % (1 Yr) Closing Price $ (9/25/14) Inspired By
INDA iShares MSCI India 2/24/14 25.06 32.69 30.15 Roubini
AMU ETRACS Alerian MLP ETN 1/27/14 17.67 23.02 32.74 Luskin
EWW iShares MSCI Mexico Capped 3/3/14 15.75 4.72 68.65 Friedman
GXC SPDR S&P China 2/3/14 13.89 6.48 78.17 Rogers
INDA iShares MSCI India 4/9/14 11.62 32.69 30.15 Kotok
GULF WisdomTree Middle East Dividend 3/10/14 11.10 38.63 23.99 Dorsey
PXH PowerShares FTSE RAFI Emerging Markets 2/17/14 10.34 3.22 20.72 Arnott
MCHI iShares MSCI China 4/15/14 9.83 5.36 48.37 Faber
EWW iShares MSCI Mexico Capped 2/11/14 9.03 4.72 68.65 Fitzsimmons
DBJP db X-trackers MSCI Japan Hedged Equity 6/12/14 8.22 10.47 38.56 Roubini
GMF SPDR S&P Emerging Asia Pacific 4/9/14 7.52 12.49 84.66 Kotok
VNM Market Vectors Vietnam 4/15/14 7.16 25.07 22.22 Faber
NKY Maxis Nikkei 225 2/3/14 6.99 1.21 17.61 Rogers
DBB PowerShares DB Base Metals 5/8/14 6.53 2.98 16.96 Gartman
BAB PowerShares Build America Bond 4/9/14 5.56 13.79 29.67 Kotok
VTI Vanguard Total Stock Market 4/28/14 5.45 16.88 101.08 Luskin
EWP iShares MSCI Spain Capped 1/27/14 5.36 16.17 39.21 Luskin
CCXE WisdomTree Commodity Country Equity 3/14/14 5.26 -0.65 29.42 Schiff
EWJ iShares MSCI Japan 3/3/14 4.95 0.58 11.82 Friedman
USDU WisdomTree Bloomberg US Dollar Bullish 4/15/14 4.46 N/A 25.91 Faber
RSP Guggenheim S&P 500 Equal Weight 3/10/14 4.37 17.19 75.75 Dorsey
IEMG iShares Core MSCI Emerging Markets 4/28/14 3.89 4.56 50.81 Luskin
VHT Vanguard Health Care 7/2/14 3.35 28.05 117.62 Yardeni
EWH iShares MSCI Hong Kong 4/15/14 2.81 7.39 20.86 Faber
ELD WisdomTree Emerging Markets Local Debt 2/17/14 2.68 -1.21 45.15 Arnott
EWY iShares MSCI South Korea Capped 2/24/14 2.49 1.38 61.73 Roubini
MUB iShares National AMT-Free Muni Bond 7/16/14 1.69 8.32 109.79 Kotok
BKF iShares MSCI BRIC 5/22/14 1.53 2.61 38.15 Arnott
XLU Utilities Select SPDR 4/9/14 1.30 14.69 41.70 Kotok
EWI iShares MSCI Italy Capped 1/27/14 0.68 8.81 15.47 Luskin
VTI Vanguard Total Stock Market 6/10/14 0.60 16.88 101.08 Friedman
SCPB SPDR Barclays Short Term Corporate Bond 3/17/14 0.34 1.20 30.68 Yardeni
EIDO iShares MSCI Indonesia 5/28/14 0.07 16.05 28.01 Fitzsimmons
FXC CurrencyShares Canadian Dollar 3/14/14 0.02 -6.93 89.53 Schiff
EWP iShares MSCI Spain Capped 2/24/14 -0.22 16.17 39.21 Roubini
EWS iShares MSCI Singapore 5/5/14 -0.23 2.69 13.39 Bremmer
EPOL iShares MSCI Poland Capped 3/3/14 -0.77 2.10 28.37 Friedman
INDA iShares MSCI India 7/23/14 -1.41 32.69 30.15 Bremmer
IEMG iShares Core MSCI Emerging Markets 6/12/14 -1.64 4.56 50.81 Roubini
FXA CurrencyShares Australian Dollar 3/14/14 -1.73 -4.59 87.96 Schiff
IYY iShares Dow Jones U.S. 9/3/14 -1.91 17.42 98.89 Dorsey
ROBO Robo-Stox Global Robotics and Automation 3/3/14 -1.93 N/A 26.44 Friedman
EWP iShares MSCI Spain Capped 3/10/14 -2.04 16.17 39.21 Dorsey
ITA iShares U.S. Aerospace & Defense 5/5/14 -2.32 17.23 106.87 Bremmer
CHIQ Global X China Consumer 3/17/14 -2.46 -8.89 13.89 Yardeni
VGK Vanguard FTSE Europe 8/19/14 -2.90 5.35 55.51 Luskin
DBGR db X-trackers MSCI Germany Hedged Equity 2/24/14 -3.14 7.77 24.96 Roubini
VIS Vanguard Industrials 7/2/14 -3.18 13.70 101.32 Yardeni
TAO Guggenheim China Real Estate 8/12/14 -3.59 0.19 21.17 Faber
RSX Market Vectors Russia 2/3/14 -4.26 -16.71 23.37 Rogers
EIDO iShares MSCI Indonesia 7/23/14 -4.37 16.05 28.01 Bremmer
FXB CurrencyShares British Pound Sterling 7/9/14 -4.98 1.09 160.39 Merk
EWL iShares MSCI Switzerland 6/24/14 -5.15 6.75 32.59 Dorsey
GDX Market Vectors Gold Miners 3/31/14 -5.32 -11.60 22.35 Merk
INDA iShares MSCI India 9/8/14 -5.40 32.69 30.15 Fitzsimmons
AFK Market Vectors Africa 5/5/14 -5.62 7.25 31.26 Bremmer
KOL Market Vectors Coal 5/8/14 -6.16 -8.82 17.38 Gartman
CHIQ Global X China Consumer 2/11/14 -6.21 -8.89 13.89 Fitzsimmons
FXA CurrencyShares Australian Dollar 7/9/14 -6.32 -4.59 87.96 Merk
EPI WisdomTree India Earnings 9/3/14 -6.71 40.05 21.69 Dorsey
FXE CurrencyShares Euro 3/31/14 -7.63 -6.14 125.65 Merk
EZU iShares MSCI EMU 6/12/14 -9.50 3.91 38.67 Roubini
DBC PowerShares DB Commodity Tracking 3/14/14 -9.60 -8.80 23.53 Schiff
DBC PowerShares DB Commodity Tracking 3/31/14 -9.92 -8.80 23.53 Merk

As of 9/25/14

 

 

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