Despite all the negative headlines facing the market, the small-cap Russell 2000 Index advanced 3.33% during August as the Volatility Index (VIX) traded towards its low of the past five years. Macro uncertainty, however, continues to abound. The minutes of the August Federal Reserve Open Market Committee meeting did little to assuage the economic debate, simply stating that "many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery."
At the same time, the economies of Europe and China continue to weaken, and the approaching U.S. fiscal cliff can only add to the uncertainty as the end of the year draws near. Worries about event risk remain elevated, yet the market has become incredibly risk-averse in its performance. One has to wonder—is defense the new offense?
To be sure, equities are climbing a wall of worry. However, from our perspective being risk averse in today's market is not necessarily risk averse. We think that chasing yield in defensive sectors—the equivalent of searching for risk-free returns—carries increased valuation risk. In looking at the performance of the Russell 2000 since its most recent high on April 29, 2011 through the end of August 2012, the best-performing sectors were all defensive in nature. These results reflected a search for "safe" yield, as these sectors look risk averse to many investors. The Russell 2000 has been led by Financials, specifically REITs (real estate investment trusts) and commercial banks, while pharmaceuticals have led Health Care, and Utilities have been strong.
At the same time, more cyclical areas of the market, those with economic risk, are trailing the overall market. In fact, the Energy, Information Technology, and Industrial sectors were the small-cap market's worst performers from the April 29, 2011 small-cap peak through the end of August 2012. Fear has driven a flight to supposedly risk-free "bond proxies" in the equity market, leaving behind inexpensive, quality businesses that generate free cash flow. We continue to believe these companies can provide solid absolute and relative returns, something we think investors are missing in today's pursuit of risk-free returns.
Our preference has always been to focus on business risk, with an attentive eye on valuation. Our valuation methodology focuses on free cash flow yields as an important metric in determining a company's absolute valuation. To us, a company's ability to generate free cash flow is often linked to its ability to sustain positive revenue growth and to generate high internal rates of return. Having the financial flexibility of excess free cash flow allows companies to focus on growth, reduce debt, or even pay a dividend. All of which, in our opinion, are markers of quality and opportunity.
P.S. Interestingly, we are not seeing big intraday swings in small-cap performance. Daily highs and lows exceeded 2% in only 12% of the trading days this year. According to Steven DeSanctis of Bank of America Merrill Lynch, "This is back to levels not seen since 2006."
Important Disclosure InformationFrancis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future.The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.
The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index.