How will the Fed taper affect small cap value?

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How will the Fed taper affect small cap value? PART 1 OF 7

Why did small cap value suddenly go red hot in the US market?

The dovish Fed fuels speculative fervor in small value—value rallies, growth sells off

The below graph reflects the outperformance of small cap value shares (blue line) versus small cap growth shares (grey line) since 1998. Note that small cap value has been a star performer post-2008 crisis—beating the Russell 2000 and vastly outperforming small cap growth. However, since 2011, like large cap stocks, small cap growth outperformed value counterparts by a modest margin. In contrast to small and large caps, mid caps saw value outperform mid cap growth by a modest margin since 2011—somewhat out of sync with its small and large cap brethren. However, since March, value is coming back with a vengeance in large, mid, and small cap stocks, with value outperforming growth by approximately 5.25%, 5.0%, and 4.25%, respectively (Morningstar total return indices). This series considers the prospects for small cap value versus growth shares in the context of the current economic environment—with specific attention to the Fed’s announcement to taper its bond purchases over the course of this year, yet keep interest rates low in view of the labor market weakness.

Why did small cap value suddenly go red hot in the US market?

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For a similar analysis of how the Fed announcement has affected large cap stocks, see Series 7-C—Will the Fed take a bite out of Apple? And for mid caps, see Series 7-D—The Fed tapers–will mid cap value hold up better then mid cap growth in Q2?

Small cap value out performance accelerates

As the above graph suggests, small cap value shares have really warmed up to the Fed announcement. It would appear that savvy investors have interpreted the Fed’s statements to mean that they will keep short term rates on hold longer than anticipated. As a result, investors have taken this as a green signal to embrace risk and go after small cap value stocks, while staying light on small cap growth stocks. The idea is that high risk, low value, beaten up companies will be receiving extended emergency benefits from the Fed. Clearly, this gesture was heartwarming for the small cap value sector, which remains hungry for growth. While this is a great momentum play, from a technical perspective, the momentum in small cap value is looking a little hot—but this is great news for the risk takers so far, in 2Q.

For an overview on the four main risk factors for equity portfolio returns, read Key strategy: 4 key risk factors as the Fed tapers.

To see how small cap value stock Sotheby’s (BID) is performing in this environment, please see the next article.

Equity outlook

Constructive macro view

Despite problems in Ukraine and China, and despite the modest consumption data in the U.S., the U.S. labor market appears to be recovering—with the exception of the long-term unemployment. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still showing a modest recovery, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find a way into a new wave of profitable investment opportunities, and significantly augment the improvement in the current economic recovery. For investors who see a virtuous cycle of employment, consumption, and investment in the works, the recent out performance of value stocks over growth stocks could become the prevailing trend, favoring iShares Russell 1000 Value Index (IWD) over iShares Russell 1000 Growth Index (IWF).

Cautious macro view

Given the China and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY) and Dow Jones SPDRs (DIA), and iShares S&P 500 (IVV). Accordingly, long-term investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD) including companies like Wallmart (WMT).


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