article 12-17-2015

These 2 Charts Show Why the Market May Be Shifting

Certain developments both in and out of the stock market recently caught our attention with a little more force than usual.

We recently talked about the dominance the Russell 2000 Growth Index has enjoyed over its small-cap value peer throughout most of the post-Financial Crisis period.

A substantial driver of small-cap growth’s relative outperformance has been the strength of small-cap companies with no earnings.

Interestingly, non-earners within the small-cap index reached a year-to-date high on 7-17, almost one month after the YTD high for the Russell 2000 on 6-23-15. From 7/17/15-12/11/15 (a period in which the Russell 2000 fell 10.8%), the Russell 2000 Growth declined 12.2% while the Russell 2000 Value lost 9.3%.

To be sure, this is a short-term period. However, the overall picture grew even more intriguing to us when we looked at it in the context of the 10-year annualized return spread between the Russell 2000 Value and Growth Indexes.

10-year Annualized Return Spread between the Russell 2000 Value and Growth Indexes

10-year Annualized Return Spread between the Russell 2000 Value and Growth Indexes

Data courtesy of Furey Research Partners

As the chart shows, in 2015 the performance advantage for small-cap growth over small-cap value (based on trailing 10-year periods) went two standard deviations above its average, which placed it outside 95% of all 10-year return periods since the inception of the Russell 2000 in 1979. This is a strong sign to us that the relative attractiveness of small-cap value seems likely to persist. 

Moving to a wider view, much of our interest in larger macro events has been keyed by greater and greater levels of uncertainty in both the U.S. small-cap market that is our perennial area of focus and, on a global level, the “Three C’s” of commodities, currency, and credit.

The last of these three is of particular interest to us lately. Credit spreads have been widening steadily for the last several months—a development that has clear implications for U.S. equities.

BofA Merrill Lynch High-Yield Master II Option-Adjusted Credit Spreads

In Basis Points Over the Last 10 Years ended 12/11/15

BofA Merrill Lynch High-Yield Master II Option-Adjusted Credit Spreads

The BofA Merrill Lynch Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond's OAS, weighted by market capitalization. The BofA Merrill Lynch High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).

If credit spreads continue to expand—as we suspect they will—then it creates a potential advantage for companies with low leverage.

As access to capital keeps tightening, conservatively capitalized companies gain an edge by their ability to self-finance their operations and to eventually be positioned to take market share from their more weary competitors. Companies with strong balance sheets rely on the credit markets far less than their more leveraged peers.

We have been waiting for more than five years for leverage to matter again to the market. To be sure, recent developments within small-cap stocks and in the credit markets have us thinking that balance sheet strength will once more be a positive factor in equity performance.

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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