Key Takeaways
- Continuing their momentum, U.S. small cap equities rose 2.8% in December, piggybacking off an 11.2% gain in November. Small caps have outperformed U.S. large caps a total of nine (9) months this year. For the year, small caps beat large caps by the widest margin since 2010, outperforming by 9.4%. This return has recovered much of the last two years’ weak relative performance. Historically, when small caps beat large caps by more than 5% in a year, they tend to slightly lag the following year. The Russell 2000 (R2K) is trading at 20.5x P/E, up from 17.4x at the start of the year and well above the 15.7x historical average. Small caps reached an all-time high on December 9th, up 3.0% from the previous record set on November 25th of this year. December has been a historically strong month and this year did not disappoint.
- For 2016, the Russell 2000 Value Index (R2KV) has outperformed the Russell 2000 Growth Index (R2KG) in nine (9) of twelve (12) months. Combining both December’s and November’s performance, Value outpaced growth by 7.1%, capping off a great performance for a year in which Value outperformed Growth by 20.4%! The outperformance was the largest victory by Value since 2001 when the “Tech Bubble” burst. Much like November, December’s performance was bolstered by the R2KV’s overweight in banks. The R2KV has over 19% more exposure to banks than the R2KG. Furthermore, the R2KG’s performance was not helped by its exposure to Biotechs, which dropped over 22% for the year. Historically, when Value wins by such a large margin, it tends to keep the momentum going forward into the following year.
- In December, Energy and Financials continued their momentum from November, driving the R2KV’s performance. Banks alone, contributed to 42% of the benchmark’s return. Energy continued to see ETF inflows, propelling performance, after both OPEC and non-OPEC countries agreed on a production cuts at the end of November. Over the last six months, Energy has either been one of the top performing sectors or the worst performing sector during a given month. Counterintuitively, interestrate-sensitive sectors, Utilities and REITs, performed well even after the Fed decided to raise interest rates for the first time in a year. Finishing the year, Materials & Processing continued its dominating performance, outpacing the second best performing sector, Energy, by 18.6%. Every sector in the R2KV was positive for the year.
- Fund flows was the theme for the fourth quarter as we saw increased inflows into ETFs. Small cap ETFs took in $17.5B for the year with over $12B in the fourth quarter alone, boosting the smallest market cap names by 27%. Active Managers continue to see outflows, aggregating over $1.5 trillion since 2005. Value managers had the worst showing in small caps with only 10.2% of managers beating the index for the year. The fourth quarter saw a slightly higher figure at 23.2%.
- The R2KV finished the year with the same theme of favoring lower quality stocks with an emphasis on companies that do not have any earnings.
Quantitative Review Of U.S. Small Cap Value
With earnings remaining weak and small caps appreciating over 20% this year, valuations have climbed to their highest level ever. The Russell 2000 (R2K) sports a P/E of 20.5x, well above the 17.4x to begin the year. The Russell 2000 Value (R2KV) also recorded its highest valuation ever at 19.6x, towering over its historical average of 13.4x. It has been widely speculated that the new administration will lower corporate taxes, which may propel small caps out of their five (5) quarter earnings recession.
December’s factors came in mixed, due to the market favoring certain sectors over others. For example, Banks, which rocketed 30% in the fourth quarter, tend to sport higher than average ROEs and a heavy weight within the R2KV, skewing the market to favoring higher ROEs for the month. Most managers, who are significantly underweight banks and tend to be higher quality, may not have seen a benefit. Fund flows propelled the lowest market cap, which outperformed for the month and the year.
Fund flows was the theme for the fourth quarter as we saw increased flows into ETFs. Small cap ETFs took in $17.5B for the year and over $12B in the fourth quarter alone, boosting the smallest market cap names by almost 40%. Value managers had the worst showing in small caps with only 10.2% of managers beating the index for the year. The fourth quarter was slightly better as this figure was 23.2%. Value managers were crushed by an underweight in banks and not owning the “right” Materials & Processing names. These two items contributed to the worst showing for Value managers since 2006, where only 6.8% outperformed the R2KV. It should be noted that the following year, 85.4% of managers outperformed the index.
Russell 2000 Value Sector Performance
Investors have been encouraged by the thought that President-elect Trump will reignite the economy as this helps Value more than Growth. The R2KV rallied 31.7% in 2016, outpacing the R2KG, which suffered its worst defeat to Value since the “Tech Bubble” in 2001. The R2KG was only up 11.3% during this period. For the year, every sector in the R2KV finished in positive territory, which cannot be said for the R2K and R2KG as Health Care finished negative. Health Care has been pummeled in both of these indices as Biotech, a significant underweight in the R2KV, dropped over 22% for the year.
Energy and Financials Services continued their momentum from November into December. Financials Services were propelled by Banks, which increased almost 8% and contributed to 42% of the R2KV’s return due to its 23% benchmark weighting. Interest-rate-sensitive REITs, led by lodging, and Utilities rallied after a poor November, with the U.S. 10-Year Treasury Note being slightly up even after the Fed decided to raise rates and its interest rate forecast for 2017.
Not only did Energy and Financial Services drive performance in the month of December, they also drove performance in the fourth quarter. Energy continued to be propelled by the announcement of an OPEC production cut, along with the participation from non-OPEC countries. This boost may be short-lived as the deal may not be enough to reduce the glut, especially if countries fail to comply.
During the year, there have been massive sector rotations driving performance. Low volatilty sectors led in the first half of the year, while Financials and Energy rotated in to propel returns in the second half. Materials & Processing continued to climb all year, returning a staggering 62.5% for the year outpacing the second best returning sector, Energy, by 18.6%.
Article by Opus Capital Management
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.
