PART TWO/ Economic And Stock Market Sensitivity
Small cap stocks have also benefited from their sensitivity to economic and stock market performance. Though partly election related, the improved U.S. economic growth outlook has helped drive outperformance of the most economically sensitive (cyclical) sectors.
The small cap Russell 2000 Index includes a 72% weighting in cyclical sectors (consumer discretionary, energy, industrials, materials, technology, and financials), compared with 69% for the large cap Russell 1000 Index [Figure 2]. Accordingly, when cyclical sectors outperform defensives, which tends to correspond to a rising broad stock market, small caps’ relative performance tends to be better. Financials, industrials, and materials each have higher weights in the Russell 2000 than the 1000, while the defensive consumer staples sector’s weight is much higher in the Russell 1000.
Small cap stocks also tend to fare better than large caps when the broad stock market rises. For example, since the stock market lows on February 11, 2016, the small cap Russell 2000 has outperformed the large cap Russell 1000 by more than 18 percentage points (43.9% vs. 25.6%). During the seven months prior to that, from June 30, 2015, through February 11, 2016, as economic conditions deteriorated, oil collapsed, China growth fears intensified, and markets and the Federal Reserve (Fed) were severely misaligned, large caps outperformed by 11.2% (-23.9% vs. -12.7%).
Looking further back, over the past 20 years, when the large cap Russell 1000 Index rose over a three-month period, the small cap index outperformed by an average of 0.78% (3.1% annualized).
Credit Sensitivity – A Blessing And A Curse
Small cap companies tend to require more access to credit markets to fund their businesses, compared with large cap companies with their typically stronger balance sheets. As such, when credit markets are healthy or improving, which tends to coincide with rising equity markets, small cap stocks have historically performed well. Conversely, when credit markets deteriorate, which typically tends to be accompanied by stock market declines and higher volatility, small caps tend to lag behind large caps.
The current environment with narrow credit spreads (investment-grade corporate bond yields relative to Treasury yields) and relatively low stock market volatility is favorable for small cap companies. We expect credit markets to get even looser after Trump and the Republican Congress take steps?—?likely in 2017?—?to ease capital requirements for banks to promote lending (though not necessarily for the biggest, systemically important institutions). The problem is that spreads tend not to tighten much further given where we are in the business cycle, and stock market volatility may revert back to normal levels, both negative for small caps.
In sum, while forecasting the timing of credit market fluctuations and market cap rotations is very difficult, we think the credit sensitivity for small caps is likely to be positive for at least the next several months; later in the year we believe periods of underperformance by small caps are more likely.
Small cap stocks have also benefited from their sensitivity to economic and stock market performance. Though partly election related, the improved U.S. economic growth outlook has helped drive outperformance of the most economically sensitive (cyclical) sectors.
The small cap Russell 2000 Index includes a 72% weighting in cyclical sectors (consumer discretionary, energy, industrials, materials, technology, and financials), compared with 69% for the large cap Russell 1000 Index [Figure 2]. Accordingly, when cyclical sectors outperform defensives, which tends to correspond to a rising broad stock market, small caps’ relative performance tends to be better. Financials, industrials, and materials each have higher weights in the Russell 2000 than the 1000, while the defensive consumer staples sector’s weight is much higher in the Russell 1000.
Small cap stocks also tend to fare better than large caps when the broad stock market rises. For example, since the stock market lows on February 11, 2016, the small cap Russell 2000 has outperformed the large cap Russell 1000 by more than 18 percentage points (43.9% vs. 25.6%). During the seven months prior to that, from June 30, 2015, through February 11, 2016, as economic conditions deteriorated, oil collapsed, China growth fears intensified, and markets and the Federal Reserve (Fed) were severely misaligned, large caps outperformed by 11.2% (-23.9% vs. -12.7%).
Looking further back, over the past 20 years, when the large cap Russell 1000 Index rose over a three-month period, the small cap index outperformed by an average of 0.78% (3.1% annualized).
Credit Sensitivity – A Blessing And A Curse
Small cap companies tend to require more access to credit markets to fund their businesses, compared with large cap companies with their typically stronger balance sheets. As such, when credit markets are healthy or improving, which tends to coincide with rising equity markets, small cap stocks have historically performed well. Conversely, when credit markets deteriorate, which typically tends to be accompanied by stock market declines and higher volatility, small caps tend to lag behind large caps.
The current environment with narrow credit spreads (investment-grade corporate bond yields relative to Treasury yields) and relatively low stock market volatility is favorable for small cap companies. We expect credit markets to get even looser after Trump and the Republican Congress take steps?—?likely in 2017?—?to ease capital requirements for banks to promote lending (though not necessarily for the biggest, systemically important institutions). The problem is that spreads tend not to tighten much further given where we are in the business cycle, and stock market volatility may revert back to normal levels, both negative for small caps.
In sum, while forecasting the timing of credit market fluctuations and market cap rotations is very difficult, we think the credit sensitivity for small caps is likely to be positive for at least the next several months; later in the year we believe periods of underperformance by small caps are more likely.
