article 09-19-2016

The Small-Cap Rally Is Broadening

What's making this quarter so interesting for small-caps? Co-CIO Francis Gannon explains.

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The big story in small-caps so far in 2016 remains the revival of small-cap value's leadership over small-cap growth. But the third quarter is an interesting story in its own right.

With a little more than two weeks to go, we're seeing ongoing strength for small-cap stocks. The Russell 2000, Russell 2000 Value and Russell 2000 Growth all showed healthy advances both year-to-date and from the end of June through the end of August (and into mid-September as well). Year-to-date through 9/15/16, the Russell 2000 Value Index was up 12.5% versus 5.9% for the Russell 2000 Growth.

Small-Cap Value Leads YTD, Trails Growth QTD
Russell 2000 Value and Growth Returns, 12/31/15-9/15/16 and 6/30/16-9/15/16

Small-Cap Value Leads YTD, Trails Growth QTD

One of the most intriguing developments in small-cap this quarter is the margin separating growth and value. From 6/30/16-9/15/16, the Russell 2000 Value increased by 6.0% while the Russell 2000 Growth advanced 7.6%.

So far, then, the quarter appears to be a catch-up period for many small-caps that did not fully participate in the initial phase of the rally off the 2/11/16 low for the Russell 2000. This has meant higher third-quarter returns for micro-caps, growth companies, and lower-quality businesses (as measured by earnings, profitability, and returns on invested capital).

Are we concerned, then, that the third-quarter moves mean a resumption of the unfortunate pattern that marked 2011-2015, in which most small-cap investors gravitated to safety and/or high yield at one extreme and speculative growth at the other?

We are not. In sharp contrast to other periods, such as 2015, small-cap sector strength has been widespread in the quarter (and in 2016 as a whole). From 6/30/16- 9/15/16, the Information Technology, Financials, Health Care, and Industrials sectors made the greatest contributions to third-quarter-to-date returns, and only two sectors—Telecommunication Services and Utilities—were negative.

Widespread Small-Cap Sector Strength QTD
Sector Contributions to Russell 2000 Returns, 6/30/16-9/12/16

Widespread Small-Cap Sector Strength QTD

1Real Estate, formally part of Financials, became a separate GICS sector in 3Q16.

It's important to remember that this strength has come across a broad range of industries within these four sectors—and that each is among the most diverse in the equity universe.

Expanding breadth and ongoing positive returns through much of the asset class are welcome developments, even if higher-quality small-caps spent much of the summer in the back seat.

To be sure, the summer months were placid—as they have often been—which we think helped certain smaller, lower-quality companies to come close, pull even, or move ahead of their larger, higher-quality small-cap counterparts.

But volatility (as measured by the VIX) has been picking up of late. And we think there's a good chance we'll see even more market gyrations in the next few months, with two Fed meetings on tap before the end of the year, the election in November, and ongoing uncertainty about the global economy.

In other words, we don't think we've seen the last of the interesting moves within small-caps by any measure.

Stay tuned…

Important Disclosure Information

Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

The 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 Index 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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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