article 11-18-2015

Trying to Make Sense of the Small-Cap Sentiment Shift

So far, 2015 looks a little bit like 2014—at least in the way in which each year was something of “A Tale of Two Markets,” with first halves that bore little resemblance to the second.

In 2015, for example, small-cap stocks were in a markedly bullish mode until the Russell 2000 Index hit its year-to-date high on June 23. Interestingly, the non-earners within the small-cap index reached their own high almost one month later, on July 17.

Russell 2000 EARNERS VS NON-EARNERS

R2K EARNERS VS NON-EARNERS

Data from FactSet. The chart shows market-weighted companies in the Russell 2000 Index with positive EBIT (“R2K Earners) versus those with zero or negative EBIT (“R2K Non-Earners”). The index companies were rebalanced monthly for the period shown.

Since that latter date, there have been a number of interesting developments. First and most notable has been the sentiment shift between small-cap value and growth.

The Russell 2000 Growth Index has been dominant over much of the post-Financial Crisis period. Yet from 7/17/15-11/12/15 (a period in which the Russell 2000 fell 8.5%), the Russell 2000 Growth declined 10.4% while the Russell 2000 Value lost 6.4%.

This relative performance pattern resembles what investors experienced during the bearish third quarter, when small-cap value was down 10.7% versus respective losses of 11.9% and 13.1% for the Russell 2000 and Russell 2000 Growth.

We have been arguing for a while now that the equity markets are in a hinge period, one in which the combination of the sun-setting of the Fed’s interventionist policies and a steadily growing U.S. economy would reestablish more historically familiar performance patterns for stocks.

To be sure, we do not know with certainty what will happen next or when—in the market or the economy. We do know that there are a bevy of conflicting signals that we continue to watch closely as we hunt for what we think are terrific small-cap companies.

Consider the following: 2015’s third quarter saw a considerable global growth scare, which led to a pronounced increase in uncertainty about the U.S. economy.

This, however, was followed by a highly encouraging October jobs report, which was then followed by several sour stock market sessions as investors fretted over poor results from some notably large retailers and the increasing likelihood of a rate hike.

It is our view that the long-looming rise in interest rates will be a positive development for equities, especially those that are profitable, well-managed, and conservatively capitalized.

Indeed, it seems clear to us that investors have already priced in most, if not all, of their collective anxiety about a rate increase.

In any case, we see the inevitable increase as a sign that the U.S. economy—uncertainty over China, the rest of the emerging markets, and Europe notwithstanding—remains solid and is fully capable of functioning without the well-meaning ministrations of the Fed.

Stay tuned…

Important Disclosure Information

Francis Gannon is Co-Chief Investment Officer and Managing Director of Royce & Associates, LLC, investment adviser to The Royce Funds. Mr. Gannon's thoughts and opinions expressed in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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