Timely Opportunity for US Small Cap Stocks
First 20% Decline in Almost 5 Years for U.S. Small Cap Stocks. The current 20% decline in the Russell 2000 Index from the June 23, 2015 peak through the end of January 2016 represents the first major decline in almost five years and creates a timely opportunity to buy high quality, fast growing U.S. stocks.
Length and Magnitude of Historical Corrections. Historical bear markets in small cap stocks last approximately 8-12 months and witness a 30% decline according to Furey Research analysis. While there may still be another 7% - 10% decline over the next few months, the average forward 1-year return from this point in a bear market is +13%. Given the difficulty in perfectly timing “the bottom,” history suggests that investors should begin to rotate towards U.S. small cap stocks today.
Investor Sentiment. The percent of U.S. investors that are bullish according to the AAII Investor Sentiment Survey is near record lows at less than 22%. This extreme reading is close to two standard deviations from the long-term average. Over the past 28 years, investor sentiment has only been this negative less than 5% of the time and the average forward three-month return is approximately +6%.
Source: AAII, Redwood Investments - 7/24/1987 - 1/21/2016
Valuation. The Russell 2000 has moved from historically high P/E levels to slightly below the 30-year average for the first time in three years. The valuation looks more compelling given the interest rate environment. During other periods of low interest rates, P/E valuations were materially higher. The last time P/E multiples and interest rates reached these levels at the same time was Q2 2012, which immediately preceded a period of strong absolute returns for U.S. small cap stocks.
IPO Market Freeze. When the IPO window closes, less new capital comes to market. The lack of new supply contributes to better forward returns. Over the past 27 years, whenever there are 10 or fewer IPOs priced over a 3-month period, the Russell 2000 return over the ensuing 12-months averages +26.6%. In December 2015 there were two IPOs and zero in January 2016. By the end of February, the cumulative number of IPOs priced during the past three months will likely be less than 10. The last two times the number of IPOs fell to this level was May 2009 and October 2011, which both began periods of above average returns for U.S. small cap stocks.
Federal Reserve Rate Increases. Small company stocks have historically generated positive 12-month forward returns 5 out of 6 times after the first rate increase.
Technical Indicators. The market correction has caused technical indicators, such as the 14-week Stochastic reading and percent of stocks trading above their 50-day moving average, to reach extreme readings that were last observed after the bear market in the third quarter of 2011. Small company stocks have historically generated positive forward 12-month returns 4 of the last 5 times after such extreme levels.
Summary. Market timing is notoriously difficult and we would not recommend attempting to call the precise bottom in the U.S. market. The combination of valuation, sentiment, technical, and historical data, however, suggest a timely opportunity to allocate funds to this attractive asset class after the first 20% correction in nearly 5 years. We look forward to the opportunity to discuss Redwood Investments’ U.S. Small Cap Growth strategy with you soon.