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- After taking it on the chin in October, U.S. small cap equities rose 11.2% in November, extending their year-to-date lead against the S&P 500 by 8.2%. Small caps have outperformed large caps in five (5) of the last six (6) months. Strong performance in November was driven by higher interest rates and the potential for an inflation pick up, which propelled the U.S. dollar higher. A strengthening dollar has historically boded well for small cap performance. The Russell 2000 (R2K) is now trading over 20x forward P/E, which is a level not seen since 2001. Though no new tax policy is for certain with a Trump presidency, hypothetically, if corporate taxes were cut to 22%, small caps would sport a forward P/E of 16.9x, which is still well above long-term historical averages. Small caps reached an all-time high on November 25th, right before December, a month that has historically had strong performance.
- For 2016, the Russell 2000 Value Index (R2KV) has outperformed the Russell 2000 Growth Index (R2KG) in eight (8) of the first eleven (11) months, with November having the largest outperformance this year. Value outpaced Growth by 4.3% for the month. In November, the R2KV’s overweight in banks boosted performance with increased speculation of the Federal Reserve raising rates for the first time in a year. The R2KV has over 19% more exposure to banks than the R2KG. For the year, the R2KV continues its dominating lead over the R2KG by 16.7% even though Value lagged Growth from February 11th until September 30th.
- November’s performance was bolstered by the likely candidates; Energy, Materials & Processing and Banks. For only the second time this year, every sector posted a postive return in November. Sectors that performed relatively poorly were those that are sensitive to higher interest rates, i.e., REITs and Utilities. Over the last five months, Energy has been either one of the top performing sectors or the worst performing sector during the given period. For the past four months, if Energy’s return has been positive, the market’s return has also been positive, and vice-versa. Though Energy is a nominal weighting within small caps, it has fueled investor sentiment that has continued to drive many sectors that have an indirect exposure to oil. For the year, Materials & Processing continues its dominating lead, while Energy jumped to the second best performing sector for the year during November.
- The R2KV continued its theme for the year of favoring lower quality stocks with an emphasis on companies that do not have any earnings.
U.S. Small Cap Value
Coupled with extended valuations and a slow start to earnings season, small caps took it on the chin in October, but came roaring back post-election on speculation of lower corporate tax rates and a strengthening dollar, which has historically boded well for small caps. Valuations remain elevated at over 20.0x forward P/E, which is over one standard deviation above its historical average. Though no policy is certain with a Trump presidency, it has been widely speculated that the new administration will lower corporate taxes. If the tax rate was cut to 22%, the forward P/E for small caps would be 16.9x, still above historical averages. If companies feel comfortable with fiscal policies and start to pick up spending, this will help boost GDP. Small caps thrive on better GDP growth and we would see a pick up of earnings and sales growth.
October exhibited a glimmer of hope with the market favoring higher quality stocks, but this was short lived after November’s performance was buoyed by companies that do not have positive earnings. Lower quality and lower market cap outperformed as we saw increased inflows into small cap ETFs, which throw a blanket over the universe, buying the smallest and most illiquid names.
Lower leverage prevailed this month with expectations of higher interest rates in the future as economic data has continued to favor an interest rate hike in December. This is the second month in a row that lower leverage has outperformed and only the third time since May. The fastest growers trailed by over 3%, thus Value outperformed Growth in the month. Though dividend payers lead year-to-date, non-yielders have outperformed in four of the last five months.
Russell 2000 Value Sector Performance
Last month, October did not have a single sector post a positive return. Ironically, November bucked the trend by having every single sector sport a positive return for the month, bringing every sector positive for the year. For the R2KV, Energy and Materials & Processing were throttled forward at the end of the month after OPEC announced that it had agreed to curb production, driving oil up 8% on the last trading day of the month. This boost may be short-lived as the deal may not be enough to reduce the glut, especially if non-OPEC countries fail to comply. Inadvertently, the OPEC deal could create a lifeline for shale producers as increased oil prices could entice U.S. drillers to pump additional crude, potentially capping crude prices.
Furthermore, interest-rate-sensitive REITS and Utilities underperformed as the U.S. 10-Year Treasury Note skyrocketed on expecations of the Fed raising rates in the middle of December with stable economic data continuing to pour in. On the other hand, Banks, which benefit from higher rates, drove the Financial Services sector along with Steven Mnuchin’s, Donald Trump’s pick for Treasury Secretary, rumored policy of loosening lending restrictions as he targets the repeal of Dodd-Frank.
At the end of October, there were two sectors that had negative performance for the year, Health Care and Consumer Discretionary, both of which turned positive. Health Care was bolstered by BioTechs, which were depressed due to the expecation of a Hillary Clinton victory and her public dislike for pharmacutical pricing strategies. Consumer Discretionary, which has a relatively “cheap” valuation against the market, was driven higher by a stronger economy.
For the year, Materials & Processing continued its outsized performance, returning an astounding 61.9% for the R2KV. This is almost 25% higher than Energy, which overtook Technology as the second best returning sector for the year. Health Care continues to be a laggard due to BioTech’s underperformance throughout the year. For the second time this year, every sector has a postive return year-to-date.
Opus Capital Management
This monthly market overview focuses on quantitative factors that have impacted the small cap market over the prior period. This is a standardized report on factor behaviors from the previous month along with trends that the market has recently exhibited. Be sure to subscribe to our Insights blog to follow along with our latest thinking.
Article by Opus Capital Management