IJR and small caps: 2nd best buying opportunity in a decade (NYSEARCA: IJR)

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Thesis and background

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 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: Market Sector Dashboard.

Some general impressions of the market and the iShares Core S&P Small-Cap (IJR) ETF this month:

  • The yield spread between the IJR and the risk-free rates is currently at a very attractive level. With a YS Z-score close to 0.82, IJR (and the small cap sector) is at a very attractive valuation in a decade – in fact, only next to the COVID 2020 panic selling.
  • The scoreboard also shows that the IJR is also attractively priced compared to other sectors. And besides the small cap sector, the energy sector is also undervalued, followed next by the healthcare sector.
  • Surprisingly, the overall market (represented by a simple average of the sectors in the scorecard) has a slightly positive return differential relative to cash risk (Z-score of around 0.1%). To us, this signals that equities, especially high-quality stocks with a reasonable valuation, are more favorable than bonds.
  • Finally, the results and dashboard also apply to other similar funds, such as the Vanguard Small-Cap Index Fund ETF Shares (VB) and the iShares Trust – iShares Russell 2000 ETF (IWM), because these funds are quite similar and their valuation close. correlated.

With the general discussion above, we now move on to the specifics of the scoreboard and the IJR.

Dashboard

Source: author

Small Cap Funds

Source: Portfoliovisualizer.com

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 bright 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 IJR 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 due to:

  • 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 after adjusting interest rates, the current valuation of IJR is at an attractive level.

The following graph shows the yield spread between the IJR and the 10-year Treasury note. Dividend yield is calculated based on TTM dividends. As can be seen, the spread is limited and treatable most of the time. The gap has been between about -2.0% and 0% most of the time over the past decade. Such a handy YS suggests that when the spread is near or above 0%, the IJR is significantly undervalued relative to the 10-year Treasury bond (i.e. I would sell bonds of the Treasury and would buy IJR). In other words, the sellers of IJR are willing to sell it to me (essentially an equity bond with embedded growth) at a return equal to the risk-free return. So it’s a good deal for me. And vice versa.

You can see the screaming signal in 2020 when the yield spread hit the 1.5% level – and that’s why this dashboard is the first thing we look at when making our investment decisions.

As of this writing, the spread is around -0.18%, as you can see. This is a level near the broader end of the historical spectrum and above the historical average by a wide margin. Such a yield spread provides a healthy cushion for investors in the near future.

Yield gap

Author based on Seeking Alpha data

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 chart below, this is especially the case for the IJR. This chart shows the IJR’s two-year total return (including price appreciation and dividend) when purchased with a different yield spread. There is a positive and quite strong trend, with a Pearson correlation coefficient of 0.88.

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 deviation is around -0.5% or when the Z YS score is positive, the total returns over the next two years have all been positive and quite large (all greater than ~ 20% in any case).

At the time of this writing, the yield gap is -0.18 and the Z YS score is 0.82, close to the wider end of the historical spectrum, in fact only next to extreme conditions that occurred during the COVID 2020 crash. Such a wide YS and such a wide Z-score suggest very manageable valuation risks in the near future and very favorable odds for significant returns.

YS

Author based on Seeking Alpha data

YS-Z score

Author based on Seeking Alpha data

Conclusions and Final Thoughts

We use a sector dashboard to take the pulse of the market and its main sectors. For this month, our main observations are:

  • IJR (and the small cap sector) now has a very attractive valuation in YS terms relative to risk-free Treasury rates. Its yield spread is -0.18 and YS Z score is 0.82, close to the wider end of the historical spectrum, actually only next to the extreme conditions that occurred during the COVID crash of 2020. Such a wide YS and such a wide Z-score suggest very manageable valuation risks in the near future and very favorable odds for significant returns.
  • The above dashboard and conclusions also apply to other small cap funds, such as VB and IWM due to their similar indexing.
  • In addition to small caps, the energy sector is equally valued, followed by the healthcare sector.

Thanks for reading and I look forward to your comments!

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