Solid rebound potential for Small caps

After outperforming large caps off the March 2009 lows to the end of 2013 (+30.6% for the Russell 2000 vs 25.9% for the S&P 500, in annualized terms), the performance of the two groups has since diverged. By late January, the Russell 2000 had reached bear market territory (down 20% or more from its highs). As a result, the Russell 2000’s valuation premium over the S&P 500 has narrowed to its lowest point in at least 6 years (see below), thereby reconstituting the relative upside potential of the former over the latter.

As well as the potential for catch up and re-rating, there are other reasons for optimism on this front.

Solid rebound potential

With the market already down more than 20% (the Russell 2000 lost -25.7% from its high on June 23 2015 to February 11 2016), research by Royce reveals that in eight of the nine previous bear markets within the Russell 2000, the market was up on average 17.3% over the following 12 months.

In other words, considerable damage has already been done and the market is poised for a rebound.

A period of mean reversion in favour of value vs. growth

The well documented outperformance of growth vs. value is as large on a 10 year trailing basis as it was during the dot.com bubble back in 2000. This time it was largely driven by the market’s infatuation with biotechs, which rose 25.4% in 2014 and 11.1% in 2015 (they were up 44% at one point in 2015). This points to the potential for mean reversion.

On that front, value stocks may have already turned a corner, pointing to better times ahead. Year-to-date (YTD) through March 31, the Russell 2000 Growth has lost -4.77% while the Russell 2000 Value is up +1.18% (-1.77% for the overall index).

Small caps are less vulnerable to a strengthening US dollar

The consensus regarding a continued appreciation of the US dollar against Emerging Markets (EM) currencies as well as the euro, given the diverging trajectories of central bank policy in the US and the Eurozone, is certainly not as strong as it was coming into 2016. If, however, the US currency did continue to rise, small and micro caps seem in a better position to withstand the storm.

On average, the higher domestic orientation of small and micro caps compared to large caps implies they should be less affected by a stronger currency, all else being equal.