Principal and Portfolio Manager Francis Gannon provides thoughts regarding the economy, the markets, and small-cap investing. Francis, a former panelist on Louis Rukeyser's Wall Street, has 19 years of investment management experience and joined our team in 2006.
Four years after the onset of the global financial crisis, the world economy continues to struggle. Developing economies are still the main driver of global growth, but their output has slowed compared with the pre-crisis period. To regain pre-crisis growth rates, developing countries must once again emphasize internal productivity enhancing policies. While headwinds from restructuring and fiscal consolidation will persist in high-income countries, they should become less intense allowing for a slow acceleration in growth over the next several years." —Global Economic Prospects, The World Bank, January 2013
As we start the New Year the economy and markets are revisiting a familiar pattern. In each of the past three years the economy and the equity markets began the year showing signs of strength. Yet in each year the economy slowed down in the late spring or early summer, raising concerns about a "growth problem" that influenced the actions taken by policymakers, especially the Fed, and hampered equity market performance. This year seems no different—at least for the moment.
The Russell 2000 Index gained 6.3% in January 2013, hitting a new all-time high. The small-cap index gained 17.6% from its fourth-quarter low of November 15, 2012 through the end of January 2013. Volatility—as measured by the CBOE Volatility Index (VIX)—was down more than 30% from January 2012. At the same time, equity correlations are beginning to fall as macro fears seem to be fading into the background. According to a recent article in Bloomberg, correlation as "a measure of how much the 2,073 companies in the FTSE All-World Developed Index swing in unison has dropped 31 percent since June, the biggest retreat since at least 1993, according to data compiled by Societé Générale SA and Bloomberg."1 This correlation indicator ended last month at its lowest level since 2007. One has to wonder whether falling equity correlations portend a different environment for 2013 or yet another dismal spring-time correction.
Looking at the long-term history of the market, we see that equity correlations tend to spike in times of crisis or distress, often as macro-driven concerns swamp individual company fundamentals. Over the past several years this has clearly been evident within the smaller-company world. Economically sensitive companies have been penalized due to ongoing global macroeconomic growth issues, while defensive companies—or at least those perceived to be—have benefited from a crowded flight to safety.
In fact, in a recent research report Furey Research Partners looked at industry group valuations relative to their history within the Russell 2000 and found that "real estate (REITs) valuations are currently 60% above historical average, while food, beverage, and utilities have valuations that are 30% higher than historical average." On the other hand, some of the more economically sensitive sectors of the Russell 2000, such as the "semiconductor and energy industries have valuations that are 15% below historical averages." We are confident that lower levels of correlation should help the stock prices of stronger businesses with attractive long-term prospects.
For the moment, the market is caught between surprisingly steady fourth-quarter earnings results in the face of slowing topline revenue and disappointing economic releases, in particular the negative fourth-quarter GDP of -0.1%. Could this be the beginning of another economic growth scare and will there be a corresponding equity correction? We are not sure. We do know, however, that corrections happen. From our perspective, they are part of the small-cap landscape and occur on a regular basis. They are neither unusual nor unprecedented. Using the Russell 2000 as an example, the small-cap index has had 20 downturns of 10% or more since its inception in 1979; the two most recent occurred in 2012.
While calendar-year declines have occurred about every third or fourth year, downturns of 10% or more have taken place about every other year. Though bear phases are always unpleasant, they remain in our view a necessary component in building strong long-term returns. Market corrections serve an important function for us, allowing for the accumulation of well-run companies at attractive prices. After all, total return is a function of entry price.
While there are no easy answers to the questions of what happens next and will the pattern of the last three years be broken, we have always believed in the importance of focusing on what we know and not worrying about what we cannot control. As correlation continue to abate, stock performance should better reflect underlying fundamentals and therefore reward effective stock picking. It is a process that we think has already begun.
P.S. Considering January's strong performance, it is interesting to note that in the 33 years since its launch, the Russell 2000 provided an 11.4% average annual total return for the 33 year period ended December 31, 2012. Interestingly, the small-cap index has never returned between 6% and 16% in any calendar year—in 19 calendar years returns were 16% or greater and in 14 calendar years, 5.9% or lower.