Equity Market Returns – A Wild Start To 2016 Follows An Eventful 2015

Last year saw growing anxiety over the “4 Cs” of commodities, currency, credit, and China — worries that were intense even before the massive sell-off that has so far characterized 2016. Yet we have also seen several developments that bolster our optimism for better times ahead.

Goodbye To All That

It was the sort of year that, when you first look at the final equity market returns, might seem unexceptional, almost quiet.

It is only when plugged into the context of the long, mostly bullish market since March 2009 that 2015’s more muted results begin to make more sense—one could even be forgiven for wondering why the losses for the major domestic stock indexes were not steeper than they were at the end of December, considering the heights to which most indexes ascended following the end of the Financial Crisis.

Yet the mostly single-digit losses that marked 2015 were the first negative calendar-year returns for small-caps since 2011 (as measured by the Russell 2000 Index). For their part, large-caps, as measured by the Russell 1000 and S&P 500 Indexes, had low single-digit positive returns.

An equally important contextual piece is the larger macro situation—and few stock market cycles have been shaped as deeply as the current period has been by forces beyond the companies themselves.

So while factors such as interest rates, commodity prices, technological innovation, consumer confidence, and the like always influence the movement of share prices to some extent, the fragility of the global economy in the years following the crisis has resulted in levels of central bank and other government interventions not seen since The Great Depression.

These actions were almost assuredly necessary to keep the economy afloat. At the same time, however, these policies—particularly zero interest rates and quantitative easing—had significant unintended consequences.

And only now, a full seven years after the tumult, is the situation in the U.S. slouching toward something resembling the Old Normal—that is, a business cycle in which access to credit is more constrained, borrowing has a cost (however low) and both financial health and profitable execution are likely to matter to investors.

To be sure, the road back has proved both longer and more winding than any of us could have foreseen at almost any point over the last seven years. At this writing in January of 2016 we know the path in front of us will have its own share of formidable challenges as we embark on the latest leg of the journey.

As equity investors, we find ourselves in a curious, ambiguous place. The number of risks affecting share prices (among other things) is long and somewhat chilling: Weak commodity prices, flagging currency in China, elevated credit concerns, and geopolitical instability.

By year-end, the spread between the U.S. 10-Year note and the Two-Year note—which, when it inverts, often signals recession—had narrowed to a point near the bottom of its six-year range at about 122 basis points. Still far from inverted, it is worth keeping an eye on.

We also saw widening credit spreads, a growing number of defaults, and additional signs of a potential credit crunch, especially in the energy industry. Our concerns over credit only intensified in light of the market’s mild reaction to the Fed’s hike on December 16.

The situation is of particular interest and concern to us as small-cap specialists. As has been the case historically, a significant deterioration in access to capital would likely have a larger negative impact on small-caps, especially those carrying excess leverage.

Of course, this development could also produce an advantage for more conservatively capitalized small-cap businesses—and we own plenty across our value, core, and growth strategies. This is one facet of what we believe is a strong case for disciplined, contrarian, bottom-up small-cap approaches that put a premium on managing risk.

More widespread success for these kinds of approaches would be a welcome departure from 2015, to which we are happy to say, “Goodbye and good riddance.”

“A Wild Ride to Nowhere”

Our own Charlie Dreifus described 2015 as “a wild ride to nowhere.” We can think of no more fitting way to characterize the year, which was distinguished by high volatility and broadly divergent sector and industry results.

The market’s indecision and frustration displayed itself with 19 crossings back and forth over the flat line for the S&P 500. There were single-digit gains in 2015 for a few global and domestic indexes—and single-digit losses for several more. The important exceptions to the downward trend were the Nasdaq Composite, U.S. large-caps, and European issues—small-caps in particular.

The Nasdaq Composite was the clear domestic leader in 2015, while the large-cap Russell 1000 and S&P 500 just barely escaped a volatile and bearish December to finish with modestly positive results.

Equity Indexes – As of December 31, 2015 (%)

  • The Calendar Year Was a Wild Ride To Nowhere—2015 saw single-digit losses for a number of global and domestic indexes. The important exceptions to these mostly modest equity declines came from U.S. large-caps, the Nasdaq Composite, international small-caps, and European issues (especially small-caps).
  • Longer-Term Perspective—Returns Moving Lower Toward More Historically Typical Levels—Three- and five-year returns remained higher than their long-term rolling averages but were down noticeably from where they were for the same periods through 6/30/15. Large-cap led for the three-and five-year periods ended 12/31/15, followed for both periods by the Russell Midcap, Russell Microcap, and Russell 2000. The Russell 2000 Growth outpaced the Russell 2000 Value for the three- and five-year periods ended 12/31/15.
1YR 3YR 5YR 10YR
Russell 2000 -4.41 11.65 9.19 6.8
Russell 2000 Value -7.47 9.06 7.67 5.57
Russell 2000 Growth -1.38 14.28 10.67 7.95
S&P 500 1.38 15.13 12.57 7.31
Russell 1000 0.92 15.01 12.44 7.4
Nasdaq Composite 5.73 18.37 13.55 8.55
Russell Midcap -2.44 14.18 11.44 8
Russell Microcap -5.16 12.7 9.23 5.13
Russell Global ex-U.S. Small Cap 0.5 4.32 1.87 4.4
Russell Global ex-U.S. Large Cap -5.02 2.07 1.4 3.25
Russell Europe Small Cap 9.37 10.97 6.69 5.76

Within our chosen specialty of small-cap stocks, there were strong returns for Health Care and discrete, more growth-oriented pockets of Information Technology that were accompanied by losses for each of the index’s eight remaining equity sectors, including Energy, Materials, Industrials, and Consumer Discretionary.

Along with Information Technology, those four sectors have been among our largest portfolios weightings and/or substantial overweights versus our Funds’ respective benchmarks over the last few years.

One can get a sense of how confounding 2015 was by noting the confluence of losses for Energy and Consumer Discretionary, which defied the historical trend of low energy prices creating widespread demand for discretionary purchases.

Indeed, traditional retail stocks were a particular source of red ink for the sector, in spite of consumer confidence remaining high and select, mostly large online companies scoring significant successes. In fact, the 4.4% decline for the Russell 2000 in 2015 masks just how challenging it was to find strong small-cap performers, especially outside the bio-pharma complex.

The difficulty becomes clearer in the context of the small-cap index’s decline of 10.1% on an equal-weighted basis in 2015. (Similarly, the S&P 500 was also down on an equal-weighted basis, falling 2.2% for the calendar year.)

Looking within small-cap from a style perspective reveals another year in which the Russell 2000 Growth Index, which was down 1.4%, outpaced the Russell 2000 Value Index, which lost 7.5%. Yet small-cap value actually fared better than its growth sibling during the third-quarter correction, losing 10.7% versus 13.1%.

Perhaps more interestingly—to us, at least—small-cap value led from the July 17, 2015 high for small-cap non-earners through year-end, falling 8.0% compared to an 11.3% decline for small-cap growth. Down and flat markets have

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