It’s Time To Get Excited About U.S. Small Caps

When the VIX hit 36 at the end of December 2018, the last thing we would have thought would be that risk-on strategies might have a strong month in January 2019. It would have represented a strong trend reversal.

But it’s exactly what happened.

Late-Cycle Rallies Are Not Unusual

2018 was a volatile year—and it felt even more volatile than it was because the risk that had manifested in 2017 was so low. There is also no question that the U.S. economy is late in the current cycle. The current expansion by the National Bureau of Economic Research (NBER), measured during the summer of this year, indicated that we may see the longest expansion on record in the post-World War II period.

Growth is slowing as the strong stimulus provided by the 2017 tax cuts wears off. But it’s important to recognize that corporate earnings growth is still alive and in the double-digit territory as we begin 2019. Importantly:

  • Policy remains the “X” factor. The final outcomes of the U.S. government shutdown, the U.S. vs. China trade discussions and the Brexit situation are all very difficult to predict. All we can do is try to bring discussions back to fundamentals, such as earnings, in order to better deal with short-term factors that have a higher likelihood of certain negative impacts.
  • Figure 1 shows that in December 2018, when perceptions and sentiment were stressed and in risk-off mode, the Russell 2000 Index dropped farther than the S&P 500 Index. During the risk-on period in January 2019, the Russell 2000 Index outperformed the S&P 500 Index, showcasing the capability of small caps to respond quickly in a positive direction as conditions change.

There is no way to be certain that negative sentiment won’t rear its head again in 2019. But we believe in the diversification potential of having some allocation in small caps to respond quickly during those times when markets recover and sentiment shifts back into the risk-on mode.

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