Stephen Wood, PhD, is Chief Market Strategist, North America for Russell Investments. In this email interview with SmartBrief, Dr. Wood discusses what is driving gains in the stock market, whether that performance will continue and investor sentiment.
Dr. Wood conducts research on, and acts as one of Russell’s external voices for the economy, capital markets, portfolio strategies and investor behavior. Dr. Wood works closely with Russell’s institutional clients and retail partners to communicate Russell’s global market perspectives, investment process and portfolio management strategies. He joined Russell in 2005.
Question: U.S. small-cap stocks have had a stunning year-to-date. What has been supporting this strength?
Answer: U.S. markets have seen incredible gains thus far in 2013. In fact, 98% of the U.S. equity market — as reflected by the U.S. large-cap Russell 1000 Index and U.S. small-cap Russell 2000 Index — has reached all time highs throughout the year.
- The Russell 2000 Index returned 31.3% year-to-date as of November 5, putting 2013 in the running to become the highest annual return since 2004, and the second highest since 1995.
- U.S. small-cap stocks have outpaced U.S. large-cap stocks by nearly 5% with a 26.6% return for the Russell 1000 Index for the same time period.
- The Russell 2000 Index reached a record close in the third quarter of 2013, and reached its all time high and year-to-date peak at 1121.07 on October 29.
The third quarter of 2013 proved the adage, “the market climbs a wall of worry.” Despite significant economic and political uncertainty, third quarter 2013 performance from small caps provided significant lift for the year, outpacing large-caps — 10.2% for the Russell 2000 Index versus 6.0% for the Russell 1000 Index — and propelling small-caps to the head of the pack on a year-to-date basis. Performance in the quarter was driven by Technology, Producer Durables and Healthcare gains — 13.9%, 12.2% and 14.7% respectively. Materials & Processing, Energy and Consumer Staples also saw healthy returns, up 10.8%, 14.7% and 13.8% respectively, though with less impact on performance due to lower weightings in these sectors.
Micro stocks, macro trends
On a relative percentage basis the recent U.S. equity market surge was supported by the smallest of the small-cap stocks. Meanwhile, larger, higher-quality stocks in the small-cap universe lagged marginally. Microcaps, which make up approximately 50% of the Russell 2000 Index, were up a remarkable 34.9% year-to-date as of November 5, 2013, as measured by the Russell Microcap Index.
While politically driven market uncertainty in the U.S. — resulting from the recent sequester, government shutdown and debt ceiling debate — appears to have caused U.S. small-cap investors to lean towards more defensive names in recent weeks, though strong performance has persisted. We see this strength as a direct reflection of U.S. relative global economic strength. U.S. small-cap stocks can be more closely connected to U.S. market dynamics than large-caps, with Russell 2000 Index companies generating approximately 84% of their revenue within the U.S., versus 70% U.S. revenue for Russell 1000 companies. Consequently, small-cap stocks can be sensitive to the condition and direction of the U.S. economy. What we’ve seen so far in 2013 is a convergence of factors that have combined to make U.S. small-cap stocks highly appealing to investors.
Small cap fear gauge near all time lows
A rally in small caps is usually viewed as a sign of growing investor confidence. And we are seeing further signals that this is the case. The U.S. small cap ‘fear gauge,’ the CBOE Russell 2000 Volatility Index, is hovering close to all-time lows, reflecting potential improvement in investor sentiment.
Q: Now that the U.S. market has surpassed the highs of 2007, is continued outperformance sustainable or should investors be prepared for a reversal?
A: The U.S. is modestly in recovery. This is supported by a timid expansion in key jobs numbers and improving housing metrics. Monetary policy remains accommodative and we’re seeing more than decent earnings data. We see the U.S. economy growing at closer to 3% in 2014 with a more muted potential for upside. From a global standpoint, the trend still points to U.S. strength. While there are signs of life globally — Europe, while lifting out of recession, remains a slow grower, China is engineering a landing and Japan is just beginning reform — serious global equity market acceleration may not quite be at hand.
U.S. economy in better shape than the U.S. government
We do believe that markets may experience volatile periods amid moderating near term macroeconomic data. We expect the U.S. economy to show greater strength in early 2014. Barring significant additional fiscal tightening in 2014, Russell expects:
- U.S. payroll gains to average 200,000 — or higher — jobs per month in the next 24 months.
- Year-on-year real GDP growth of 2.9% in 2014.
- The 10-year U.S. Treasury yield to reach approximately 3.2% by the end of the third quarter 2014 with a gradual return to historic interest rate levels.
Equity market volatility can be expected — for example, surrounding the Federal Reserve’s decision to taper its asset purchase program, or further government gridlock — however, this may also represent a buying opportunity for long-term investors. We expect that U.S. equities may benefit from some upside potential coming mostly from earnings-per-share gains. And we don’t believe that the Federal Reserve’s Quantitative Easing policy has significantly distorted asset prices. In our view, current asset prices are fairly valued, justified by the combination of stable economic growth, low inflation and moderate corporate earnings growth.
Q: We’ve seen mixed asset flows into small caps and U.S. equities in general. Have investors been participating in the run up?
A: Timing the market is nearly impossible for even the most sophisticated and well informed investors. And we are seeing that asset flows over the course of the past year both in small caps and large caps have been mixed at best.* It has been a great five years, but the average investor has not necessarily been participating in these returns:
- Five year annualized performance for the Russell 2000 Index is 18.1% as of November 5, 2013.
- Annualized performance since the market peak on July 13, 2007, is at 7.1% as of November 5, 2013.
- Annualized performance since the market trough on March 9, 2009, is 29.6% as of November 5, 2013.
U.S. equity inflows data as well as the seesaw between defensive and dynamic, indicate that investors still have a cautious tone about the recovery. Within the context of an actively managed multi-asset solution, we believe clients, working with their financial advisor, can have greater assurance that they are taking a holistic approach to their investment exposures, providing more control over their investment outcomes.
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* Morningstar DirectSM U.S. Open-End Asset Flows Update, October 2013 (data as of September 30, 2013).
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