The major U.S. stock averages ended the quarter solidly higher, and very near all-time highs.  However, unlike most of the last few years, the source of returns was decidedly different. 

After years of the very largest technology stocks accounting for the lion’s share of market gains, this year so far has been marked by a welcome rotation into smaller stocks and so-called “value” stocks.  As a result, the small-cap Russell 2000 index has outperformed the large-cap S&P 500 by a wide margin this year, up 12.7% vs. 6.2%.  And within the Russell 1000 (large caps), value outperformed growth by an even wider margin, up 11.2% for value vs. 0.9% for growth.  Many of our small-cap and value-oriented stock funds produced double-digit returns this quarter.  Within the S&P 500, the leading sectors have been Energy, Financials and Industrials, all outpacing Technology, after years of lagging behind.  This rotation is something we have long anticipated, based primarily on valuation disparity.  But it nevertheless begs the question: “Why now?”

Over the past several weeks, you may have heard or seen that interest rates have been creeping up.  And stocks sold off a few percent from the February highs as the markets attempted to digest a swift move up in the yield on 10-year Treasuries.  The 0.83% increase in the yield on the 10-year Treasury was the largest quarterly move since Q4 2016.  For our balanced accounts with large bond positions, the news was mixed.  Absolute returns from our bond funds ranged from roughly -3% to +2%, and in aggregate we were probably about breakeven on all our bond positions, dampening the strong returns from equities.  On the other hand, our bias toward short-duration, high-quality bonds meant that many of our positions outperformed the benchmark.  While rising rates hurt bond prices, ultimately, once rates stabilize, it will allow for bond positions to produce more meaningful income yield.

The sharp jump in yields (albeit from an incredibly low base to a still very low level by historical standards) spooked the markets about the threat of inflation.  To be clear, we do view inflation as a legitimate concern.  However, we think we are a long way from a level of inflation that warrants any immediate concern.  To the contrary, we view higher rates as normal, healthy, and appropriate for an economy in recovery.  The pundits will point out that what really matters is whether rates are rising for the “wrong reasons” (i.e. inflation) or the “right reasons” (i.e. improving economic fundamentals).  After some collective hand-wringing, the market has concluded that the “right reasons” prevail.  And that is the camp we are in, at least for now. 

However, even when interest rates rise for the “right reasons,” it has implications for stock valuations.  Valuation multiples (i.e., P/E ratios) come down, but more so for highly valued growth stocks than lower-priced value stocks.  Likewise, earnings estimates improve, but less so for growth stocks than value stocks with more cyclical earnings.  The combination of those forces makes lower P/E stocks with more cyclical earnings much more attractive on a relative basis than their higher P/E, higher-growth counterparts.  And that explains why small caps are outperforming large and why value is outperforming growth. 

Long-time readers of our commentary know that we have, perhaps stubbornly, adhered to the view that owning small-cap stocks and having a value tilt would ultimately work in our favor, and we are glad to see it.  Astute followers of our previous letters may notice that the one area that we have long favored that has yet to reward our dogged determination is international.  Granted, they have generated solidly positive returns in the quarter and over the last year, but still lag behind the U.S.  Perhaps the biggest surprise here is that we expected the rest of the world to emerge from the pandemic sooner, based on the early pandemic response efforts, but the aggressive rollout of vaccine here in the U.S. may have helped us accelerate our recovery despite our higher case counts.  Regardless, if inflation does ever present problems in the U.S., a weaker dollar will make overseas assets more attractive, and we think continued exposure is an excellent hedge against those risks.