Big Style Shifts In Small Caps

by: FTSE Russell

By Tom Goodwin, Senior Research Director

As anyone who has examined market trends to understand market performance knows, trends can sometimes be difficult to identify. Sometimes they're gradual and unpronounced while other times they are dramatic and become apparent more quickly. As we have discussed in an earlier blog, one such dramatic shift occurred within the sectors of the US small cap universe between the fourth quarter of 2016 and the first quarter of 2017. But it was not the only one. Here we will look at the recent flip-flop in style preferences within the small cap universe and what it might say about current market sentiment.

After the US election in November of 2016, we saw substantial growth in US small caps, with the Russell 2000® Index increasing by 8.8% for the quarter. This was likely in part the market's reaction to the then president-elect's promises of tax cuts and infrastructure spending. These campaign promises were particularly beneficial to small cap companies, which generally have more domestically focused businesses. However, as the chart below shows, the focus in the fourth quarter of 2016 was on value and defensive styles - generally considered a "risk-off" approach.

Russell 2000 style indexes performance Q4 2016, Q1 2017 and Q2 2017

Source: FTSE Russell. Data as at June 30 2017. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

A very different sentiment emerged as we entered 2017. There was a dramatic shift to what is considered a more "risk-on" approach as value and defensive styles were traded out for growth and dynamic. As illustrated above, this trend has continued through the second quarter of 2017.

One explanation for this significant style shift might be that small cap volatility is currently well below average. Low volatility often gives market participants more confidence about the stability of certain segments of the market. Using the CBOE Russell 2000 Volatility IndexSM (RVXSM), we can see below that the index hit a maximum level of 20 in the second quarter of 2017, which is significantly less than the 10-year average of 26.

Russell 2000 Index implied volatility

CBOE Russell 2000 Volatility Index (RVX), June 2007-June 2017

Source: CBOE. CBOE®, Chicago Board Options Exchange®, CBOE Volatility Index®, and VIX® are registered trademarks of Chicago Board Options Exchange, Incorporated (CBOE). RVX is a service mark of CBOE. The Russell 2000 Index is a registered trademark of The Frank Russell Company, used under license. This data is believed to be correct but CBOE does not guarantee the accuracy of the data and will not be held liable for consequences of its use. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

In view of the big style shift within the US small cap universe from a risk-off to a risk-on stance, it seems market participants are feeling more confident in the strength of the US economy. This sentiment has been mirrored by the Federal Reserve's moves to raise rates and wind down the quantitative easing programs established during the Financial Crisis in 2008. As we move through the back half of 2017, it will be interesting to see if the risk-on trend continues.

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