Is The Small-Cap Rebound Sustainable?
Eric Corbeil-Brisighello | Apr 22, 2016 09:53
On February 10th, Federal Reserve Chairwoman Janet Yellen headed to Capitol Hill for two days of congressional testimony. Chair Yellen then acknowledged that financial conditions in the U.S. became less supportive of growth, and if prove persistent, could weigh on the outlook for economic activity and the labor market. She also noted that foreign economic developments posed risks to U.S. economic growth, highlighting that declines in the value of the yuan intensified uncertainty about China’s exchange rate policy and the prospects for its economy. A lot has changed since Yellen’s semiannual congressional testimony: financial conditions have eased sharply, the yuan strengthened against the U.S. dollar, and both credit growth and real estate investment in China rebounded strongly. The resulting improvement in market sentiment led to a strong rally in global equities with the S&P 500 up 14% since.
Moreover, the accompanying rebound in commodity prices, decline in market volatility, tightening in credit spreads, and dovish tone from the Fed all played a significant role behind the small-cap outperformance in both Canada and the U.S. since the market bottomed on February 11th. Indeed, the S&P/TSX Small Cap index is up 26% since that date against an increase of 14% for the S&P/TSX 60. In the U.S., the Russell 2000 is up 19% vs. a rise of 14% for the S&P 500 since February 11th.
Canada
The small-cap outperformance in Canada since February 11th can entirely be explained by the strong rebound in materials stocks. Indeed, the materials sector has the largest weighting in the S&P/TSX Small Cap, with a 37% weighting in the index. This compares to a 10% weighting in the S&P/TSX 60 index.
Our quantitative model for timing relative performance between small and large capitalization stocks in Canada had already started a bottoming process at the end of 2015, suggesting that small-cap underperformance was possibly in its late innings. This model is based on a large series of macroeconomic and financial indicators that historically proved to be good predictors of relative performance between large and small caps. These indicators include changes in earnings estimates, forecasted long-term earnings growth, yield curve, and price momentum variables, among others. As illustrated below, our size rotation model (the blue line) performed well in forecasting major turning points in the relative performance of smaller capitalization stocks (the yellow line) over the past ten years, with a lead time ranging from one to seven months.
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Even though our Canadian small/large model did no longer foresee small-cap underperformance, it didn’t confirm the small-cap outperformance seen since February 11th and remains for now in a bottoming process. History shows us that our size rotation model can evolve quickly and we thus intent to closely monitoring the situation over the next few weeks to see how our investment recommendations need to be adjusted to take any future changes into account. For now, we still favour large-cap names as we expect the Fed tightening cycle to resume in June. In our view, the recent easing in financial conditions combined with the strong labor market conditions and improving economic data in the U.S. should improve Fed officials’ confidence that inflation will return to the 2 percent target over the medium term. This should likely lead to a re-pricing of the Fed hiking path and moderated USD upside, which should contain future gains in the value of precious and base metals. On the other hand, the recent pick-up in the growth rate of floor space under construction in China, the stabilization of the Chinese economy according to the OECD leading indicator and our expectations that global economic growth could soon rebound should support metal prices and the relative performance of small caps.
United States
The small-cap outperformance in the United States since February 11th can largely be explained by the decline in market volatility, tightening in credit spreads, pick-up in manufacturing sentiment and the dovish tone from the Fed. Contrary to Canada, small-cap names in the U.S. continue to underperform large-cap stocks, on a year-to-date basis.
As illustrated below, our U.S. size rotation model does not yet forecast an imminent turning point in the relative performance of smaller capitalization stocks. As a result, we continue to favour large-cap names in the U.S. This quantitative model has also performed well in forecasting major turning points in the relative performance of small caps over the last ten years, with a lead time ranging from one to three months. For example, our size rotation model started to decline in the fourth quarter of 2013, with the Russell 2000-to-S&P 500 ratio only starting to drop late in the first quarter of 2014.
Again we are monitoring the situation very closely to see how our investment recommendations need to be adjusted as the recent rebound in the ISM Manufacturing index above the 50 expansion/contraction threshold provides an important catalyst for a period of sustained small-cap outperformance. The current rise in the ISM new orders-to-inventory components ratio also suggests that the ISM Manufacturing index should continue to improve. On the other hand, our expectations for a coming rebound in market volatility could soon negatively impact the relative performance of small-cap names.
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