In a world where economic and geopolitical uncertainties seem to rule the day, investors are still favoring risk assets. Why? It’s simple: because stocks tend to rise and fall when conditions are better (or worse) than expected, and what we’ve seen more often than not in 2016 is that data has been surprising to the upside.
Think about some of the disparities between expectations and reality that we’ve seen so far this year. Predictions of a catastrophic hard landing for China? Overblown. Fears that Brexit would mean disaster for the European Union and create economic havoc for every country involved? Overblown. You could keep that list going on for a while.
These ‘disconnects’ help give upward support to stocks. But, one thing we’ve noticed this year so far is that investors are increasingly moving out on the risk curve, to even riskier types of stocks—namely, small caps. Through the first week of August, the Russell 2000 Index (which has an average market cap of about $1.72 billion) rose about 7% versus the 5.8% of the large cap S&P 500. In July, which was the month the world was responding to the Brexit shock, small and mid-cap stocks actually outperformed their large cap peers in eight of the ten sectors, and the smallest 50 stocks in the S&P 500 outperformed those at the top.
Leadership between asset classes, styles and market cap changes hands often so it is not too surprising to see small cap outperform as part of a cyclical ‘changing of the guard,’ so to speak. But, we think there is more to the story than that. Here are four additional forces we see at work:
- Capital Inflows to the United States – I’ve talked about this plenty in past writings, but we’re seeing more foreign capital entering the U.S. because risk assets here represent the best option from a fundamental standpoint, even though they already trade at a fairly high premium. Investors are willing to pay premiums for solid corporate fundamentals in a country with relatively stable growth.
- No Yields in Bonds and Dividend Stocks Are Expensive – bond investors are fatigued with the lack of yield and the realization that it’s not going to change anytime soon. We’ve seen stocks with favorable dividend yields get bid-up to higher valuations of late, with ‘defensive’ categories being the best sector performers (healthcare, utilities, consumer staples). But, as investors flock to these categories, multiples are being bid-up, and stocks are becoming expensive. That means investors are moving even further along the risk curve to look for yield at more reasonable valuations.
- Investors Anticipating Future Earnings Growth – earnings growth is expected to rebound in the second half of the year, and cyclical categories are expected to feel some of the tailwinds from a restored appreciation of the corporate earnings outlook. We may be starting to see some ‘bidding up’ of prices vis-à-vis future growth expectations.
- Sentiment is Still Pessimistic but Improving – investors are still largely skeptical about the state of the global economy, but with stocks still on the rise and big events (Brexit, China economic fears) not materializing into anything dire, sentiment is starting to improve. Improving sentiment is actually something to keep a close eye on. As investors start to get complacent about how high of a premium they’re willing to pay for risk assets, it could lead to bidding valuations going too high (bubble forming).
Bottom Line for Investors
Investors’ resurging appetite for risk assets means that riskier asset classes have seen some relative outperformance of late. Does that mean investors need to switch gears and shift assets into categories like small and mid-cap? My answer to that would be: you should already have exposure to those categories! As part of a well-diversified portfolio that is managed for risk, it is Zacks Investment Management’s belief that investors seeking growth should have exposure to small cap, mid cap, and large cap stocks, and that their equity exposure should match their desire for growth and their risk tolerance. Thinking about that approach in the context of this article, it would have also meant seeing your portfolio participate in the outperformance of small cap stocks of late.
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