- After a year of strong absolute returns and increased momentum heading into the new year, U.S. small caps had to rally on the last trading day of the month to pull performance into the black. After small caps outperformed U.S. large caps in nine (9) months last year, January proved to be the turning of the tide as large caps outperformed small caps by 1.5%. The lore of the “January Effect” indicates that a weak January, when large caps beat small caps, leads to the full year of weakness for small caps.Historically, when small caps beat large caps by more than 5% in a year,they tend to relatively lag the following year. Small caps are trading at a 15% premium to large caps, which historically, have traded at a 4% premium to small cap. This is quite a jump as the valuation spread was only 11% at the beginning of the year, but increased due to lower expected earnings growth within small caps.
- For 2016, the Russell 2000 Value Index (R2KV) outperformed the Russell 2000 Growth Index (R2KG) in nine (9) of twelve (12)months, with a total outperformance of 20.4%! This was the largest victory by Value since 2001 when the “Tech Bubble” burst.January was littered with numerous trend reversals when compared to 2016. First, Value slowed its momentum with the R2KGoutpacing the R2KV by 2.3%. Also reversing its trend, biotechs propelled Health Care’s performance in January after posting a negative 22% return last year. Growth was also a beneficiary of the fastest growers, which rebounded after an abysmal 2016.Finally, when Value wins by such a large margin against Growth in the previous year, it tends to keep the momentum going forward into the new year, another trend that was not supported in January.
- Continuing it momentum from 2016, Materials & Processing was the best performing sector within the R2KV for January, driven higher by increasing metal prices. Banks pulled back during the month as investor skepticism grew that only portions of Dodd-Frank may be repealed. Energy, a strong overall performer in 2016, also declined with skepticism that the OPEC production cut will not hold up over the long term.
- After seeing inflows of over $17.5B last year, small-cap ETF flows continued their momentum as we saw another staggering in flow of $3B in January. Counterintuitively, the largest market cap names outperformed in the month. The biggest winners for the month were non-earners, due to the outperformance in biotechs, and the fastest growers, which helped Growth beat Value.
- Active management saw a turnaround in January after a dreadful 2016. Almost 50% of core managers outperformed the benchmark, with Value and Growth managers faring much better. Growth led the charge with 73% of managers beating the benchmark while Value managers were not far behind, posting a 67% figure.
- Fourth quarter earnings season has started off sluggishly for small caps as the Street now expects anemic sales growth of 1.4%and profits to be down -0.5%.
- Since Election Day, the CBOE Volatility Index (VIX) declined over 50%, the largest 12-week decline in its history.
Performance Drivers of Russell 2000 Value (Top Quintile vs. Bottom Quintile)
Many of last year’s trends reversed in January. Higher market cap, which lagged last year, performed well, even with inflows of $3B into small cap ETFs. In 2016, the Russell 2000 Growth Index (R2KG) relatively underperformed against the R2KV due to the fastest growers and biotechs performing poorly, both of which, performed well in January. On the other hand, non-earners, a leading factor last year, continued its run. A common theme for asset classes of all sizes, dividend payers lagged non-payers. Overall factors for January were mixed as we saw non-earners continue to drive performance, but higher growth and larger market cap, which are higher-quality metrics, also performed well.
Valuation for U.S. small caps continue to be elevated, especially after last year’s relative outperformance versus U.S. large caps. The Russell 2000 Index (R2K) still trades above 20x forward P/E. This is well above its historical average of 15.7x. Small caps now trade at a 15% valuation premium compared to large caps, up from an 11% premium at the beginning of the year. Small caps have historically traded at a 4% premium to large caps. This premium was driven higher, even with January’s relative underperformance, due to lower earnings estimates for small caps. The Street now estimates anemic sales growth of 1.4% for small caps in the fourth quarter, with profits expected to decrease by 0.5%. Despite an improving economy, small caps are expected to remain in an earnings recession. If companies feel comfortable that Washington will proceed with fiscal stimulus and tax cuts, we may see increased capital expenditure spending, which tends to benefit small caps more than large caps.
Russell 2000 Value Sector Performance
The “January Effect” indicates that a weak January, when U.S. large caps beat U.S. small caps, leads to a relative weak performance year for small caps. When small caps have trailed large caps in January, small caps have averaged a gain of 4.5% during the full year versus 9.0% for large caps. When the reverse is true, small caps have gained 19.3% against a 12.2% return from large caps.
After a strong rally in 2016, the R2KV cooled off in January, as the index declined -0.7%. The R2K and R2KG both posted positive performance, returning 0.4% and 1.6%, respectfully.
After the outsized return by Materials & Processing in 2016, its momentum continued as it was the best returning sector in the R2KV for January, driven by increasing metal prices. Energy and Financial Services’ good fortunes turned in January as oil prices declined during the month and banks’ hot performance cooled. REITs and Utilities, which tend to trade together due to their sensitivity to interest rates, traded in opposite directions. Utilities were up 1.3% while REITs traded down 1.2%. Biotechs were up nearly 5.3% in the R2KV and 7.3% in the R2KG, a large contributor to the R2KG’s outperformance against the R2KV, given the latter’s underweight.
Active managers had a solid showing in January after an abysmal 2016. Last year, only 10% of Value managers outperformed the index, which was the lowest figure since 2006, when only 7% outperformed the index. The following year, 85% of managers outperformed. In January, small cap managers had a good showing with 50% of core beating the index. Growth and Value managers fared better with 73% and 67% outperforming, respectively. This was a very good showing for Growth, even when biotechs, a perpetual underweight for managers, drove performance. On the other hand, Value, which also had a great showing in January, benefited from lackluster performance in banks, where managers are, on average, 6% underweight against the benchmark.
Volatility has been very low by historical standards, and saw its largest decline over a 12-week span following the election. This low volatility environment may not be sustainable with President Trump’s plethora of executive orders, coupled with the potential for the Fed not hitting their goal of three rate hikes this year. An increase in volatility tends to benefit active managers, who hold higher-quality companies, which have historically performed better during periods of heightened volatility.
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