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Small caps are best play against inflation risks: Analyst

David Wagner, Aptus Capital Advisors Portfolio Manager joins the Yahoo Finance Live panel to discuss the latest with the markets.

Video Transcript

ZACK GUZMAN: I want to shift back, though, to the market action we're seeing play out-- all three major indices in the green, but as we've been discussing, somewhat of a rotation maybe coming undone a bit. We've talked so much about growth stocks and the way that they were hit in that rotation towards value names-- cyclicals. Today, though, let's dig into that a little bit deeper here with our first markets guest in the noon hour, that would be David Wagner, Aptus Capital Advisors Portfolio Manager joins us right now.

And David, appreciate you taking the time here to chat. I mean, one thing that stood out in the last couple of days, and, obviously, it's to be expected when we think about the moves in oil, but what's your take, maybe, on how the energy sector in general has just been beaten down and maybe overlooked here-- how that plays into an outlier or maybe a dark horse in this value versus growth discussion, and how maybe people should be playing that now?

DAVID WAGNER: Yeah, you know, I think canary in the coal mine would definitely be tossed around for that right now. You know, how I see-- you know, I think the long-term argument, you know, hey, is a value trade going to continue? Is a growth trade going to revert back-- kind of like what we saw in April. The big question right now, especially over the last few days, is, hey, is this a head fake?

And you know, what we've really learned over the minimal amount of value rallies that we've seen here is that there's a head fake by growth on average about one out of every three months. And you know, I think that's kind of what we're seeing right now. Zack, you mentioned valuations before-- value stocks as a whole, cyclical stocks as a whole are very, very undervalued relative to growth stocks. And especially if you're some type of believer in inflation, you know, you really want to play those cyclical areas of the market.

You know, if you think value will outperform and that this is a growth head fake, you know, you're going to be very bullish on industrials, materials, like you said, energy right there. You know, if you have some type of increase in the yield curve to really continue to have banks continue on, you know, that value trade can persist. And this actually may just be some type of head fake from growth right now.

And at Aptus right now, that's actually what we think. We think that valuation for value over growth is just very compelling right now, given the fact that growth has outperformed the value for you know eight years now. You know, it's a leadership change, and that's normal really coming off of some type of market bottom out of a recession.

AKIKO FUJITA: What do you mean by that when you say, a head fake for growth? I mean, what specifically are you seeing and? What do you think investors should be cautious on?

DAVID WAGNER: You know, I think the big thing that investors should be cautious on right now-- and it's actually really directly tied to kind of this value versus growth trade, it's also tied to kind of an equity versus fixed income trade-- you know, it feels like every day I wake up as Bill Murray on "Groundhog Day." You know, you really look towards the direction of interest rates.

And what the bond market is telling us right now relative to the equity market is something completely different. If you go back to I think it's about March 31 of this year, the 10-year treasury has been trading in a range of about 1.5% to 1.7%. So the bond market right now-- and the bond people tend to be the smart people in the room. That has a bad connotation in investment terminology, but they tend to be the smart people.

And the fixed income market right now is kind of telling us, OK, you know, pun intended, we're taking the fed at face value right now that we're going to get some type of transitory inflation. We don't think that there's going to be a long duration, also pun intended, of some type of inflation moving forward, while the equity market is really telling you something very, very different.

As I just mentioned, since March 31, the 10-year treasury has been very much range-bound-- a very, very bullish tone to bonds. But if you actually look underneath the hood of what is moving the S&P 500, what's moving small caps-- virtually any type of equity right now is some type of inflationary-tied you know, sector or subsector. You know, you've got, let's say, metals and miners up 15%, 16% off during that time period to go back towards that March 31, very much giving some type of inflationary tone.

And you know, you can-- the bond market and equity market, they're giving us two different signals right now. Both can't be right. So I think over the next few months, we're really going to kind of see that play off as, you know, who is right here, the bond market or the equity market?

ZACK GUZMAN: Yeah, it was interesting to see even the Fed in one of their research paper talking about how they're seeing indicators flash different signs there. They don't know if it means the labor market has more slack or less slack due to some of the data coming in here-- a lot of unknowns in the current time period. But I guess the last takeaway I'd want to get from you, David, is if you are an investor out there trying to see who's going to be right, who's going to be wrong, if there is the best way to maybe hedge against some of the volatility we might see upcoming here. What would be the advice there?

DAVID WAGNER: Yeah, so I think the best way to play this-- and some people may call me crazy-- is given the potential for inflation here, the Fed commentary right now-- if inflation turns out to be real, the best thing to play, in my opinion, is small caps over large caps. You still want to stay in equities over bonds, given where interest rates stand on bonds.

You know, traditional fixed income, we kind of want to throw out the window here. So given where the Fed's talked right now, we actually want to be in small caps. The reason for that is small caps are the only major asset class since the 1930s to outperform inflation in every single decade. And most people probably think that's crazy, but it's true.

And why is it? Small caps are able to be very much more nimble than their larger cap brethren when it comes to passing along, you know, an increased materials cost, increased cost of goods sold to their end users so they can maintain their margins. And that's why small caps tend to outperform, you know, in every single decade greater than inflation. So if you do truly believe in inflation to occur, I would place small caps. And then what I mentioned before, you really, is kind of the value tilted indices.

ZACK GUZMAN: All right, David Wagner, Aptus Capital Advisors Portfolio Manager giving some key takeaways there-- appreciate that.