How will the Fed taper affect small cap value?

Part 4
How will the Fed taper affect small cap value? (Part 4 of 7)

Will the Fed’s tapering eventually crush small cap value?

When rates rise, things could change

The below graph reflects the modest outperformance of small cap growth over small cap value since 2011, as viewed on a year over year total return basis through 2013. As noted in the prior article in this series, small cap value, on a cumulative total return basis, is still the better long-term performer by a large margin. With the recent Fed taper announcement, growth has taken a step back in the past few weeks, underperforming value by around 5.0%. Looking forward, changes in the interest rate environment could lead to revaluations of all large, mid and small cap companies. The post-2008 outperformance of growth versus value in the large and small caps can continue to reverse, and fast money takes profits from where momentum has been the greatest—that means growth for small and large caps. This would suggest that value may hold up better than growth, but given the tremendous momentum in small cap value shares since 2008, it is possible that small cap value could be ripe for long-term-driven profit taking relative to small cap growth. This article considers the implications for small cap value versus small cap growth shares in the current economic environment with specific attention to the Fed taper announcement.

Small Cap Value  GrowthEnlarge Graph

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

Why small cap value stands out

As described earlier, value outperforms growth in the long run, so investors are often more comfortable with a more passive strategy of buying and holding value investments. Plus, the smaller the market cap of the company, the greater the positive returns tend to be in the long run. However, as noted earlier, the smaller the market cap of the company, the more volatile the returns are as well. What makes small cap value stand out at this time is the exceptional outperformance they have had versus benchmark indices since the 2008 recovery. As noted in prior articles in this series, mid cap value outperformed mid cap growth over time, though was still slightly under its S&P 400 mid cap benchmark. Similarly, large cap growth outperformed large cap value since 2008, though was still below its S&P 500 large cap benchmark. As noted in the first article in this series, small cap value has handsomely outperformed the Russell 2000 index, while small cap growth has lagged the Russell 200 index on a total return basis.

The Fed tightens—the end of the flight from quality?

Relative to small cap growth shares, small cap value shares have been the strongest performer, and investors who have concentrated investments in this sector have been handsomely rewarded for taking the risk that comes with owning the most volatile sector of the market. As was the case with large, mid and small caps in the 2008 crisis, the value sector shares were hit the hardest. Greenspan’s interest rate hikes from 2004 through 2006 were intended to cool the housing sector bubble. Two years into the tightening cycle, the Fed succeeded in cooling everything. It is possible that the current round of Fed tightening could eventually have a similar effect—though this time the focus could be more on speculative froth in the equity market versus the still cool housing market. Clearly, in the current environment the Fed is not raising interest rates per se, by raising the overnight Fed funds rate, which will likely remain near zero for some time. However, the withdrawal of their bond purchases could lead to higher rates in the longer end of the yield curve, and this could impact equity valuations. It is also not good for new home buyers, as mortgage rates could get higher. As far as small cap value is concerned, this has been a high flying sector for some time, and investors who have reaped great rewards in their small cap value portfolios might wish to take profits as the taper ensues, and cash in their profits if an unanticipated rate shock hits the market.

The economic outlook—conducive to mid cap growth, or simply speculative froth?

The four recent macroeconomic series noted below have described the U.S. economy in considerable detail, painting a supportive picture for ongoing economic recovery, although they also underscored risks for continued double digit equity returns.

  1. The U.S. government spending: As noted in a prior series on the U.S. macro economy, the U.S. government is back on budget, which has taken some pressure off of deficit spending.
  2. Labor markets: As noted in a prior series on U.S. employment data, labor markets have picked up dramatically since 2008.
  3. The U.S. consumption: As noted in a prior series on consumption data, U.S. consumption is at a good level, though has flat lined since 2012—additional overall consumption growth is not likely.
  4. The U.S. investment: As noted in a prior series on U.S. investment data, the investment recovery is in place, though is recovering at a tepid pace, and without improvement in this area, get ready for higher taxes. Implications for equities are mixed.

To see how the March 31 Federal Reserve Bank announcement has cooled the post-2008 momentum in growth shares versus value shares, read Part 5 of this series.

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).

The Realist Discussions