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How will the Fed taper affect small cap value?

Part 5
How will the Fed taper affect small cap value? (Part 5 of 7)

Why the Ides of March cools growth momentum and rewards value

Beware the Ides of March

As the below graph reflects, March 15, the Ides of March, was followed by a significant decline in the post-2008 growth versus value rally, as reflected in the iShares Russell 1000 growth index (IWF) (red line). Although the broad markets have rallied on the Fed’s dovish commentary at month’s end, value has bounced back harder than growth, and basically continued to rally. This article considers the outlook for the Small Cap Growth Index versus the Small Cap Value Index in light of these recent developments.

March 2014Growth and Russell Indices DeclineEnlarge 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?

Dovish Fed gives economy a green signal, growth momentum cools on flight to value

 As discussed in the first article in this series, the Fed’s March 31 commentary added fuel to the small cap value rally, while the post-2008 high momentum growth sector has cooled. Although a long-term laggard, growth has been strong post-2009, outperforming value by approximately 35%. As the above graph reflects, the recent market rally has seen an increase in value, and low price to book stocks, as investors have pared their post-2008 gains in growth.  This is great news for value investors in the near term, though as the prior article in this series suggests, this trend could change if the yield curve steepns as the year progresses. Higher long term rates could reflect higher growth and inflation data in the future, and this could impact weaker companies in the value sector more than the growth sector. For the time being, it would seem that the trend is your friend, and that investors should not fight the Fed. However, investors will need to carefully monitor the longer-term interest rates. Should the five or ten-year Treasury bond rise another 1% or more, we could see a significant cooling of the speculative furvor that is chasing both value shares and high yield bonds. This flight from quality to value could reverse as the yield curve steepens, and growth could be at a premium once again.

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.

Read Part 7 of the series to see how energy-related Master Limited Partnership (MLP) Boardwalk Pipeline Partners (BWP) is faring after its recent crash.

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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