Last week, over a year after we first forecast a major short squeeze-driven outperformance of the most shorted small- and micro-cap stocks, none other than Goldman jumped on the “buy the most shorted names” bandwagon, which promptly led us to wonder if the rally in both the most shorted names, and also in the small cap Russell 2000 index, is finally coming to an end.
The reality, as the chart below shows, is that despite 2013’s rate-driven headfake, where Russell 2000 stocks have outperformed the S&P in close approximation with the 10 Year yield, whose surge was incorrectly translated as an indication of economic strengthening when it was merely reacting to fears about the Fed’s gradual tapering, that the Russell is still solidly outperforming the S&P year to date.
In fact, to many buying the Russell 2000 is merely the highly levered bet with which the bulk of institutions (recall that almost all hedge funds, and a majority of mutual funds, are underperforming the S&P for a 5th consecutive year) seek to make up for losses in their portfolios. Which is why as the next chart below shows, in a furious scramble to catch up by year end, the institutional Russell net futures (i.e. levered) positioning just hit a record high: the biggest investors are now all-in the smallest names.
And once again, as so often happens, flows are confused for fundamentals. Because even Goldman edmits that the entire outperformance of the small cap sector is purely due to multiple expansion, not from actual fundamental improvement.
So is the massively overbought small cap sector due for a correction?
With these manipulated, centrally-planned markets, nobody has any idea. However, for those who have once again bet all in, which just happens to be most plain vanilla dumb money, it may be time to reevaluate. Below is Goldman’s David Kostin with his take on what has emerged as the most overbought small cap sector in history:
Investors have cast their ballots, and so far in 2013 the vote goes to small cap US equities. 2013 has been an excellent year for US equities in
general, and an even better one for small caps in particular. The Russell 2000 has returned 28% YTD, outperforming the S&P 500 by 370 bp. Its 36% return over the last 12 months ranks a standard deviation above historical averages both in absolute terms and relative to large caps.
Small caps have outperformed large caps in almost every sector. Most notably, Russell 2000 Consumer Staples have returned nearly 40% YTD and outperformed their large cap counterparts by 15 pp. Info Tech is another notable difference, with investors citing the lack of growth among S&P 500 Tech as the reason for the small cap sector’s 33% return and 14 pp outperformance relative to the lagging large cap sector.
The two major drivers of Russell 2000 returns are US economic growth and valuation. We highlighted in April that the prospect for accelerating US GDP combined with undemanding valuation set the stage for strong returns. From May through September, the Russell 2000 returned 14%, outperforming the S&P 500 by 800 bp. After lagging by 300 bp in the last month, however, investors wonder whether the small cap rally is over.
The opposing forces of improving US GDP growth and above-average valuation suggest that the Russell 2000 will post a decent but less impressive return of 6% in the next 12 months. This compares to a historical average of 11% and implies that small caps will trade in line with large caps. We forecast the S&P 500 will reach 1850 in 12 months (also +6%).
One core pillar of small cap performance, growth, remains supportive. We expect US GDP will accelerate above-trend to a 3% pace in 2014 from under 2% this year, and remain at that rate at least through 2016. Strong expectations for earnings growth reflect the economic picture. We forecast 2014 EPS growth of 23% for the Russell 2000 compared with 8% for the S&P 500. Consensus expects earnings growth of 33% and 11%, respectively.
The other major driver, valuation, is the strongest obstacle to small caps, and the most common concern raised by investors. The Russell 2000 P/E multiple has risen 25% YTD, explaining more than 80% of the index return. It now stands above 10-year averages both in absolute terms and relative to the S&P 500. Price/book, our preferred metric for small caps, has similarly risen from a standard deviation below to nearly a standard dev. above average levels during the last two years.
Rising interest rates should be a tailwind for Russell 2000 returns. From a fundamental perspective, small cap borrow costs, and therefore margins and earnings, have a low sensitivity to changes in Treasury yields. Russell 2000 performance relative to the S&P 500 tracked the general path of yields this year, with small caps garnering most of their excess returns as 10-year yields rose from 1.7% in May to nearly 3% in September. Our rate strategists forecast the 10-year will rise to 2.75% by YE 2013 and 3.25% by YE 2014.
Several other macro factors that supported small cap outperformance of large caps this year may become headwinds in 2014. The Russell 2000 has historically outperformed the S&P 500 during periods of accelerating EPS growth, expanding P/E multiples, and a strengthening dollar. We expect S&P 500 EPS growth to decelerate to 8% in 2014 from 11% this year, and that P/E multiple expansion has largely run its course. The current S&P 500 forward multiple of 15x is in line with our year-end 2014 forecast level. Our FX strategists expect USD to weaken against EUR and GBP but strengthen relative to JPY during the next 12 months.
The Russell 2000’s leverage to domestic growth boosted the index this year but may be a detriment as growth in foreign markets improves. Roughly 80% of Russell 2000 sales are derived domestically compared with 66% for the S&P 500. This benefitted the small cap index earlier this year as investors worried about growth in Europe and Asia. Both data and sentiment have improved, however; Eurozone and China PMIs are back above 50, and regional equity markets have responded.
Positioning also poses a risk to small cap performance. Small cap mutual fund and ETF flows have totaled $22bn (5% of AUM) YTD, putting 2013 on pace to be the strongest year on record. Institutions are currently $6bn net long Russell 2000 futures, the largest position since the data start in 2006. Leveraged funds have a modest $2bn net short, a decline from their $2bn net long earlier this year but enough to rank in the 85th percentile historically.
Micro data are also mixed. 81% of Russell 2000 companies have reported 3Q results. 41% of firms beat on earnings by at least a standard deviation of consensus estimates, 25% missed, and the average surprise was 3%. These metrics are all in line with the 10-year historical average. In 3Q the NFIB Small Business Optimism Index averaged its highest level since 2007, but remains well-below average levels prior to the crisis. According to the survey, revenue growth concerns are fading, and respondents continue to point to government requirements as their most important problem.