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Small caps rebound in Q3

By: Tom Goodwin, Sr. Research Director

Often viewed as more volatile than their large-cap counterparts, historically small-caps have tended to underperform when uncertainty runs high. With no shortage of anxiety-provoking news lurking in Q3, one might have expected a flight towards alternative stocks such as large-caps, with an accompanying tilt to value and defensive stocks. Surprisingly, the markets indicated exactly the opposite.    

The main concerns affecting global markets in Q3 were a continuing fallout from Brexit, China’s wavering economy and an increasingly contentious US presidential election. But despite these anxieties, the small-cap Russell 2000 Index recorded a 9% index return for the quarter compared with just a 4% index return for the large-cap Russell 1000 Index.

As depicted below, after a rough start to 2016, US small-caps turned things around by Q3, resulting in the Russell 2000 Index showing index performance of more than 3% higher than the Russell 1000 Index year-to-date as of quarter-end.

And we can see below that while the large cap, value and defensive indexes recorded higher levels in Q1, there was an increase in the performance of the small cap, growth and dynamic indexes over the course of Q3.  Why the sudden change in leadership?

It seems that despite the election pandemonium, the US economy is still relatively strong in a global context. This relative strength appears to have benefitted US small-caps in Q3. Historically, a strong domestic economy has tended to disproportionately boost small-caps because these companies generate most of their revenue from domestic business. Large cap company revenues, on the other hand, are much more multi-national which ties them closer to the health of overseas economies.

Another factor that seemed to benefit small-caps in Q3 was a strengthening of the US dollar after Brexit. A stronger dollar negatively impacts exports for US companies and small-caps are not as highly dependent on exports as their larger-cap counterparts.  

While the third quarter of 2016 was an unexpectedly good one for small-caps, we already know that October shook the market up quite a bit. With less than two months left in 2016 and the outcome of the US Presidential election and the Fed’s December meeting to deal with, small-cap resilience will be put to the test.

For more on this topic, please refer to the quarterly FTSE Russell Small Caps Perspective Paper.



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