US Smaller Cap Market Update
By Jeff James // March 10, 2016
The US equity market has experienced a series of dramatic selloffs and rallies during the past seven months, with each peak and valley reaching sentiment extremes not seen in years. This latest rally, which started February 11, has been characterized by epic short covering, oil rebounding 40%, and many beaten-up stocks bouncing sharply off their lows. Exhibits 1 and 2 are quite telling, both for our smaller cap strategies and the market in general.
Exhibit 1 illustrates that small caps have become the cheapest they have been relative to large caps since the late 1990s. The Credit Suisse Equity Strategy’s multifactor Russell 2000/S&P 500 valuation composite has now fallen 1.16 standard deviations below its 30-year average—a level equal to the low seen in 1990, which is second only to its nadir during the 1999 market. On average, these levels have resulted in small caps (Russell 2000) outperforming large caps (S&P 500) by 8 percentage points over the next 12 months.
The near-term environment will likely remain volatile with downside moves very possible, especially given that equities have rallied strongly off of their February lows. However, based on history and our experience, we view the recent underperformance of micro and small caps as an opportunity for these stocks to outperform over the intermediate and longer term. The overall direction of the market, of course, is a different question, but the historical relative-performance comparison is interesting.
Exhibit 1: Small/large cap relative valuation—long-term model (Russell 2000 vs. S&P 500)
Source: Credit Suisse US Equity Strategy, S&P Capital IQ/ClariFi, Thomson Reuters/IBES, Compustat
As of February 29, 2016
Exhibit 2 shows the one-month change in the “medium-term momentum” risk factor over the past 20 years. The Driehaus equity investment strategies typically have a relatively high exposure to this risk factor. On March 3, 2016, the one-month change hit an extreme of -11.03%. Going back 20 years, the market has only seen medium-term momentum decline this much on a monthly basis in four other instances: April 2000, January 2001, August 2008 and April-May 2009. In the years following these extremes, the risk factor medium-term momentum outperformed significantly in three of these instances. (The exception was the August 2008 period, during which medium-term momentum was followed by a lower low in early 2009, and then realized significant outperformance.)
Exhibit 2: Medium-term momentum, one-month change (%)
Source: FactSet, Driehaus Capital Management
Looking back on my 18 years of experience as the portfolio manager of the Driehaus Micro Cap Growth strategy, this current environment displays strong similarities to the challenging markets seen in 1998, 2002 and 2011. During those periods, like this current one, many of the factors and variables that we favor were not rewarded in the short term, as compared to what typically has been seen over the vast majority of the time during the past several decades.
We seek to invest in companies that have strong organic revenue growth, improving margins and superior earnings growth. When those characteristics are combined with attractive qualitative factors such as strong end markets and industries, superior and innovative products and highly capable management teams, we have found those companies tend to outperform over time. We continue to find and invest in many companies with these positive qualities. In some rotational markets, however, fundamentally challenged and beaten-up stocks can outperform fundamentally superior stocks, as we have seen over the past month.
While we expect volatility to continue as the market adjusts to the ongoing macro headwinds, we are confident in the sustainable fundamentals of our portfolio holdings and their intermediate-term outlook as valuations and risk factors are becoming increasingly attractive.
Of contrarian note, in a sign of the acute investor bearishness, the usually ebullient Investor’s Business Daily New America column, which regularly highlights exciting, young companies, last month featured companies on two successive days that were founded in the 1800s.
This information is not intended to provide investment advice. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, market sectors, other investments or to adopt any investment strategy or strategies. You should assess your own investment needs based on your individual financial circumstances and investment objectives. This material is not intended to be relied upon as a forecast or research. The opinions expressed are those of Driehaus Capital Management LLC (“Driehaus”) as of March 2016 and are subject to change at any time due to changes in market or economic conditions. The information has not been updated since March 2016 and may not reflect recent market activity. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Driehaus to be reliable and are not necessarily all inclusive. Driehaus does not guarantee the accuracy or completeness of this information. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.