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Investment Commentary

How the Sausage is Made

By Kyle Tripp | Johnson Financial Group • January 12, 2024

3 minute read time

Some clients enjoy knowing how we make investment strategy decisions. Others have no interest—and, in fact, would rather not know how the sausage gets made (as long as it’s good). This week’s commentary is for the “tell me about it” camp. I thought I would take a minute and explain how the recent decision to increase our small-company stock exposure in client accounts came to fruition.

The “sell” decision

JFG sought to reduce small-company stock exposure in client accounts a little over a year ago because of economic uncertainty. There have been a number of studies around the size of companies and how they react when the economy slows down or when we approach different points in the economic cycle. When the economy slows, all else equal, small-company stocks tend to have a more challenging time and tend to underperform larger companies.

When to buy again?

As with any investment choice, a “sell” decision requires revisiting. When should a “buy” follow?

As it turned out, the economy did slow over the last year (though at least at this point, it has not entered a technical recession). The performance of small-company stocks, however, followed the pattern we expected. Over the last year, large-company stocks represented by the S&P 500 Index were up 26.3%, while small companies as represented by the Russell 2000 Index were up 16.9%.

The gap in the chart below shows that difference in returns.

The gap in the chart below shows that difference in returns.That data point brought us to the next potential decision point. Has the disparity in returns reflected the economic cycle softening we expected? We reviewed a great deal of economic data and valuation metrics to make that decision. For example, the valuation of large- versus small-company stocks also shows small companies to be historically cheaper than large-company stocks based on a price-to-earnings (PE) ratio metric. The smaller the number, the more attractively valued the stock is.

The smaller the number, the more attractively valued the stock is.The problem with either return disparities or other valuation metrics is that they are terrible timing tools. These kinds of differences can persist for a prolonged period of time.

So, the last part of the decision process is really identifying the catalyst for this environment to change. For this decision, it is our view that the economy has meaningfully slowed from the peak, and the Federal Reserve is likely to be at the end of its tightening cycle.

Although the economy could slow more in the coming quarters, all these data points taken together prompted us to seek an increase in our small company stock exposure to capture the potential rebound in these stocks and the economy as it occurs. Importantly, small-company stock rebounds tend to last for up to three years, so getting the exact bottom, if even possible, is not necessary to capture the performance recovery.

We also intend to continue to review the option to potentially increase our small-company exposure as additional data points become clear. Whether you enjoy knowing how the sausage gets made or not, the choice to increase our small company stock exposure has shown positive results so far.

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This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank and Johnson Wealth Inc. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE