VB and IWM: small caps remain the second most attractive sector
We use the following market sector dashboard to take the pulse of the market and its main sectors. In particular, the simple YS (yield spread, defined as the TTM dividend yield minus the 10-year Treasury rates) is the first thing we look at. They give us a 30,000 foot view of where to look further – which sector, growth stocks, value stocks, bonds or precious metals, et al. We’ll detail what each entry means in the next section, and we’ll update the dashboard monthly. Feel free to download or export the google sheet via the following link as well: Market Sector Dashboard.
Thesis and highlights
Some general impressions and highlights of the market and the small cap sector this month:
- First, the results and dashboard apply to many of the popular small cap ETFs, such as the Vanguard Small Cap ETF (NYSEARCA:VB), the iShares Russell 2000 ETF (NYSEARCA:IWM), as well as the iShares Core S&P Small-Cap (IJR) ETF. The reason is that these funds are quite similar and their valuation is closely correlated as you can see in the second chart below. As such, this article will present results for VB and IWM, but the results should be applicable to all similar funds.
- The correlation between VB and IJR is particularly close. Their performance essentially overlaps entirely. IWM has underperformed the other two funds in the past by a small margin. This is partly because the IWM is a more expensive fund. It charges an expense ratio of 0.19% compared to VB’s expense ratio of 0.05%. Such a small difference, when accumulated over a long period of time, becomes more dramatic.
- The yield spread between these small cap ETFs and the risk-free rates is currently below their historical level by a good margin. With a significantly negative YS Z-score (-0.14 as represented by the IJR), these funds are grossly overvalued relative to their historical spectrum.
- The rapid rise in treasury bill rates made the yield on these funds unattractive. 10-year Treasury yields just topped 2.7% for the first time since 2018 and are likely to rise further based on the Fed’s latest dot chart.
- The energy sector is the only sector that currently shows a positive Z-score on the yield spread.
With the general discussion above, we now move on to the specifics of the dashboard, VB and IWM.
The dashboard explained
Note: If you are already familiar with our Market Sector Dashboard, you can skip this section. It describes the mechanics of the dashboard.
- The yield gap Z-score. It measures the dividend yield of a given sector relative to 10-year treasury bill rates. How the yield spread is calculated will be detailed in the next section. A larger Z-score suggests greater undervaluation relative to the all-time high and Treasury rates. And vice versa.
- A Z-score closer to 1 means the yield gap is near the thickest level of the historical spectrum and is coded in light green. And vice versa.
- The yield gap Z-score. Similar to the Yield Spread Z-score, it assesses a given sector’s dividend yield relative to its own all-time high. A larger (more green) Z-score suggests a greater undervaluation relative to its own all-time high. And vice versa.
Yield Gap and Yield Gap Z-score
For VB and IWM bond-style equity funds, an effective way to assess their valuation with adjusted interest rates is to calculate the yield spread. The details of calculating and applying the yield spread were provided in our previous article. The yield spread is an indicator that we check first before making investment decisions. Fortunately, we have had very good success with this indicator because of:
- Its simplicity – it relies only on the simplest and most reliable data points (Treasury rates and dividends). In investing, we always prefer a simpler method that relies on fewer unambiguous data points than a more complicated method that depends on more ambiguous data points.
- His timeless intuition – no matter how times change, the risk-free rate serves as gravity on all asset valuations and therefore the spread ALWAYS provides a measure of the risk premium investors pay over risk-free rates . A large gap provides a higher margin of safety and vice versa.
In this context, you will see below that once adjusted for interest rates, their current valuations are not at an attractive level.
Take VB as an example. The following chart shows the yield spread between VB and the 10-year Treasury. Dividend yield is calculated based on TTM dividends. As can be seen, the spread is limited and treatable most of the time. The spread has been between about 0.50% and minus 1.75% most of the time over the past decade. Such a handy YS suggests that when the spread is near or above 0.5%, VB is significantly undervalued relative to the 10-year treasury (i.e. I would sell treasuries and buy VB). In other words, the sellers of VB are willing to sell it to me (essentially an equity bond with embedded growth) at a yield 0.5% above the risk-free yield. So it’s a good deal for me. And vice versa.
Similarly, you can see that the yield differential between the IWM and the risk-free Treasury rates is also limited and manageable. And the limits are quite similar. The small differences in the limits are due to the different indexing methods used in these funds. VB owns about 1500 shares while IWM owns over 2000.
You can see the screaming signal in 2020 when the yield spread has reached a level of around 1%+ – and that’s why this dashboard is the first thing we look at when making our investment decisions.
As of this writing, the spread for both funds is well below the historical average, signaling overvaluation relative to risk-free rates.
For readers familiar with our analyses, you know that short-term returns are highly correlated with the yield spread for many funds and stocks. And as you can see from the table below, this is also true for VB. This chart shows VB’s 2-year total return (including price appreciation and dividend) when purchased with different yield spreads. There is a clear positive trend and a Pearson correlation coefficient of 0.65.
Again, the glaring buying opportunities in 2020 are illustrated by the two data points on the far right of the charts. And you see the outsized return in the next 2 years. In general, also shown in the orange box, when the return gap is greater than 0%, the total returns for the next two years have all been positive and quite large (almost all greater than 25%).
You can see a very similar correlation for IWM, again, as they share a similar underlying indexing approach. Here we plot the 1-year return for IWM to show that the correlation also holds over a shorter time frame. For IWM, the positive trend is even stronger and the Pearson correlation coefficient of 0.77. Also shown in the orange box, when the return gap is greater than 0%, the total returns over the following year have all been positive and even greater (all greater than around 20%). And when the return gap is greater than 0.5%, total returns over the following year were also all around 40%.
As of this writing, the performance gap is around -1.37% for VB and around -1.67% for IWM, respectively. And both are significantly below their historical average.
Conclusions and risks
We use a Market Sector Dashboard take the pulse of the market and its major sectors. For this month, our main observations are:
- Soaring Treasury rates act like gravity on all sector valuations, and small caps are no exception. The yield spread between small-cap ETFs (such as VB and IWM) and risk-free rates has been pushed to below its historical average by a significant margin.
- Although small caps remain the second most attractive sector (in relative terms). And currently, the energy sector is the only sector that still shows a positive Z-score on the yield spread.
Before closing this article, we would like to highlight some risks and uncertainties associated with the approach described in this article.
First, despite their similarities, these small cap funds are not exactly the same. As mentioned above, VB owns about 1500 shares, IWM owns more than 2000 shares, and IJR owns about 600 shares. Although they use a similar sampling method to represent the full spectrum of small cap stocks. And suddenly, the valuations of these funds (and therefore their yield spread) will not be exactly the same but should be quite close.
Second, as detailed in our previous article, dividend yields do not always reflect company fundamentals due to the following factors:
- Tax law – the dividend can vary widely depending on whether tax codes favor it or not.
- Political climate – the dividend can also change depending on its political popularity.
- The composition of the stock index – the “market” dividend yield can also be skewed if the index is dominated by a few mega-caps that do not pay dividends – like what we are experiencing now.
- Therefore, we do not directly use the yield spread in our investment or asset allocation decisions. In practice, we first adjust the above corrections and then use the adjusted yield spread in our investment decision. But the data and approach shown here is also the first place we check.