SUMMARY: The annualized realized volatility of the Russell vs S&P 500 is in its 95th percentile. Days like yesterday’s 95th percentile outperformance of small vs large caps, with little in the way of news outside of Google’s AI problems, can happen in this kind of backdrop. Small cap vs. large cap vol should be high in the coming weeks; there is a lot of data to be released and the relative performance is sensitive to anything that shifts expectations of the length of the economic cycle.
For riskier factors, SMID caps, Deep Cyclicals to extend gains (Deep Cyclicals have been on a relative outperformance tear vs. Defensives/Early Cyclicals), and the vol spread breaking in favor of small caps, economic data can’t be too hot. A sharp increase in the USD and 10yr yields is likely if data is firm. As Peter Williams pointed out yesterday, if some of the Jan weakness in data (by weakness we mean the data that moved Atlanta Fed GDPNowcast from 4.2% to 2.9% for 1Q24) was mostly weather or post-Dec slowness related, the risk is that the payback means a mechanically hotter Feb set of data. As we know, the Fed is much more focused on stronger economic growth now and the potential for firmer economic growth leaving core inflation too high.
MORE ON SMALL CAPS: In our survey last week, investors attributed small cap underperformance to interest rate sensitivity (HERE). Small cap relative performance correlation to 10yr yields is near a record low (yields up, relative performance down).
The general line of logic we have heard from investors is that small caps need debt to grow or have significant debt rollover risk. Small cap factor exposures demonstrate the index is heavily skewed toward risk-on factors. There’s a lot of junk in the index. It will take a while for the macro picture to be clear enough for junk to have a sustained rally. Particularly if financial conditions need to tighten a bit, as Gerard wrote yesterday (HERE). Benign economic data would help.
There is still a case to be made that small caps can rally alongside higher 10yr yields IF yields are higher because of stronger growth, not tighter FCI. Peter had a report out talking about yields being biased higher because of data yesterday too (HERE). But clients are referencing a potential “shoot first and ask questions later” problem with higher yields, especially if investors are trading the IWM as an index and not the individual stocks. This emphasizes the utility in applying filters to the universe, particularly for those that don’t buy our logic that small caps performance depends on why yields are increasing. Profitability filters improve returns. More on that HERE.
Full report below…
MARKET VIEWS: Small caps outperformed large caps by +1% yesterday. That’s an 95th %tile d/d return. Google’s AI problems shaved -20bps off the S&P alone yesterday. There was little in the way of news yesterday outside of Google. FYI, the annualized realized volatility of the Russell vs S&P 500 is in its 95th percentile. Small cap vs large cap vol should be high in the coming weeks; there is a lot of data to be released and the relative performance is sensitive to anything that shifts expectations of the length of the economic cycle.
MORE ON SMALL CAPS: In our survey last week, investors attributed small cap underperformance to interest rate sensitivity (HERE). Data does bear that out; small cap relative performance correlation to 10yr yields is near a record low (yields up, relative performance down).
The general line of logic we have heard from investors is that small caps need debt to grow. There is limited lending data to use here (if you know have seen anything useful, please send it our way). NBER surveys small businesses about credit availability and the outlook for credit availability. Both are down near their 25th percentile.
Small cap factor exposures demonstrate the index is heavily skewed toward risk-on factors. The index is positively exposed to Liquidity and Earnings Turbulence, and negatively exposed to Profitability, Quality, and Low Vol. As we’ve been writing (HERE), small caps as an index are extremely sensitive to anything that shifts how long the economic expansion can continue. There’s a lot of junk in the index. It will take a while for the macro picture to be clear enough for junk to have a sustained rally. Particularly if financial conditions need to tighten a bit, as Gerard wrote yesterday (HERE).
All that emphasizes the need to apply filters to the universe. There is still a case to be made that small caps can rally alongside higher 10yr yields if yields are higher because of stronger growth, not tighter FCI. Peter had a report out talking about yields being biased higher because of data yesterday too (HERE). But there is a potential “shoot first and ask questions later” problem with higher yields, especially if investors are trading the IWM as an index and not the individual stocks. Profitability filters improve return ratios and help avoid that potential problem. This is a useful filter for those worried about higher yields, without the distinction between growth and FCI. More on that HERE.
Source: FactSet, 22V Research
