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Brett Arends's ROI: A strategy to outsmart the S&P 500 ‘bubble’

Brett Arends’s ROI

Play U.S. stock rebound the cheaper way

Two modern economists are walking down the street, chatting away amicably, marveling at the perfect wisdom of the stock market. Then one of them looks down, stops, and holds out his hand to stop his companion.

“Look!” he says, pointing down.

The second economist follows his gesture. And there, on the sidewalk, he sees a giant pile of money.

The two gawp for a second. Then the first economist bends down to scoop up some of the cash, only to be stopped by his companion.

“Don’t bother,” he says.

“Why not?”

“It’s not real.”

“What do you mean, it’s not real? I can see it right here with my own eyes.”

“It’s not real,” says the second economist, “and I can prove it. If the money were really there, don’t you think someone else would have already picked it up? What makes you think you are smarter than everyone else who has walked down this road before us? After all, the market is perfect!”

His companion thinks about this for a second. “Of course!” he says. “How foolish of me. You’re absolutely right!”

And so they walk on.

This old economists’ fable – it would be a stretch to call it a joke – is often told about modern “efficient market” economists, those who believe the market is perfect and no anomalies exist.

One wonders what they make of the situation right now.

It’s not just that the S&P 500

large company stock index is flirting with new highs in the midst of a major crisis.

It’s that small company, higher quality “value” stocks are trading at their biggest discount since the insanity of the dot-com bubble in 1999-2000.

For those who missed it: Anyone who swapped out of big tech growth stocks back then and bought “small cap value” stocks instead avoided the crash and doubled their money over the next six years, even while the blue chip index tanked.

Efficient market economists, like the pair walking down the street, will tell you that there is no such thing as found money or a free lunch. They insist that on the market, “the price is always right,” and every stock offers exactly the same risk-adjusted return as every other.

But it’s a puzzle.

If the S&P 500’s current boom makes sense, then the economy must, broadly speaking, be heading for an epic and sustained rebound from the crisis. But if that’s the case, then small-company stocks will join the party, sooner or later. Actually, as they’re cheaper they will presumably play catch up. On the other hand, if investors in small-company stocks are right to be cautious then it’s hard to see how the S&P 500 can justify levitating on its magic carpet all the way up there.

The good news is that we really don’t have to know.

Even the “efficient market” boys, like finance professor Kenneth French and Nobel laureate Eugene Fama, say that small company value stocks are better long-term investments than large company growth stocks, though they add (naturally) that they are also riskier.

Meanwhile analysts at investment manager AQR Capital calculated some years ago that small-company stocks have been a particularly stellar long-term investment if you managed to avoid low-quality companies with dubious financials.

In a nutshell: Buy high quality, small cap “value.”

And at the moment, such stocks are trading at an epic bargain compared with the S&P 500. And even more so compared with their mirror opposites on the market, “large cap growth” stocks (think, yes, the so-called FAANGs or FANMAGs or whatever we’re up to now – Facebook

and Google (“Alphabet”)

It’s tempting to retort: Well, if these small cap value stocks are such good investments, why are they so far behind the S&P 500? Which is another way of asking: If this really is a big pile of money on the street, why hasn’t anyone else picked it up?

And it’s not just about price. It’s also about dividends. When you factor those in, small cap value has crushed large cap growth stocks for most of the past 25 years. More up years. Fewer down years. And no long, miserable bear market where you lost about 80% of your money before making it back.

From the dot-com bubble, small cap value has quintupled your money. Even though today it’s way out of fashion.

It’s notable that J.P. Morgan runs the best-performing general U.S. small cap mutual fund of the past 10 years, according to Morningstar, and their chief small and mid cap stock strategist just told CNBC there are bargains galore in the field right now.

For those who want to take the bet and like a simple life, there’s a straightforward option. Choose a small cap fund that goes for “value” stocks. To screen out the lowest quality companies, find one that tracks the narrower, more selective S&P 600

small cap index instead of the broader, less discriminating Russell 2000

index. And, of course, keep an eye on your fees. Good examples include the SPDR S&P 600 Small Cap Value ETF

and the Vanguard Small-Cap 600 Value

exchange-traded funds, with expenses of just 0.15%.

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