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Small Cap Perspectives: Russell 2000 Index 3Q2016 Analysis


No big worries? Global uncertainties loom, but equities continue positive momentum, for now

The Federal Reserve still didn’t raise interest rates in the third quarter, though it insists that it’s coming sometime soon. The fallout from the “Brexit” vote is still playing out: it now looks increasingly likely that a “hard Brexit” will be the eventual outcome, where the UK will be ejected from the EU free trade zone. That would likely have a negative impact on future economic growth in the UK with uncertain impacts on Europe and the rest of the global economy. China is going through a transition from a primarily industrial and export-oriented economy to one that is has a significant consumer and service-oriented segment, with potential pitfalls that have many worried. And then there is the US presidential election. Add to that sluggish global economic growth and several nasty wars in the Middle East and Africa that appear to be getting worse, not better.

Despite this bundle of uncertainties, the market seems to have shrugged off the worries in the third quarter. Measured by Russell indexes, the US equity market in particular has continued its positive momentum for the year. The all-cap Russell 3000 Index was up +15% on September 30, 2016 year-on-year from where it was on September 30, 2015. The RVX index of expected small cap volatility, a key indicator of worry, never once exceeded its 10-year average during the quarter.

What is perhaps more notable are the changes in leadership in equity segments we have seen over the quarter. What had been a mainly large cap, value and defensive environment just a few months ago has become a small cap and growth oriented market. Many small companies in biotech, computer services and semiconductors have seen their stock prices rise in the 3rd quarter, making Technology the largest sector contributor to the Russell 2000 Index return of +9%. The defensive position of much of the market has shifted as well to favor “dynamic” stocks with more variable earnings and higher volatility. Taken together, the shift to small cap, growth and dynamic leadership are symptoms of a “risk on” market sentiment.

In part, US small caps may have benefitted from the relatively strong US economy, emphasis on “relatively.” This is a “dirty shirts” argument: when one looks at all of the economies around the globe to see where are the best prospects for growth, it’s like going to one’s closet and finding that all the shirts are dirty. Naturally, one chooses the least dirty shirt — that would be the US economy. That can disproportionately boost small caps because these companies tend to generate the majority of their revenue from domestic business. Large caps tend to have more multi-national revenue, tied to the health of overseas economies. We have also seen the dollar strengthen, especially since Brexit, which negatively impacts the export business of any US company, but those with the most export dependence tend to skew toward larger cap.

However, the argument in favor of the US economy should not be carried too far. Overseas small caps were in positive territory as well in the 3rd quarter. The FTSE Developed Small Cap ex US Index posted a 7.3% gain for the quarter (USD). This was after suffering a -1.1% loss in the previous quarter, mainly due to the Brexit shock.

Summer torpor ended abruptly on September 9th, a day after the European Central Bank decided to leave its bond-buying and interest-rate policies unchanged, rather than expanding them. Concern was aggravated by a Fed official’s comments that the Fed might raise interest rates soon. On this day, expected volatility (RVX) ticked up higher and US and overseas stock indexes tumbled, illustrating how sensitive this market has been to anticipated central bank support. It remains to be seen what will play out for the rest of the year.

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