Two topics today:
#1: Continuing with the theme of cyclical rotation we outlined last night, let’s take a historical look at how the Russell 2000 performs relative to the S&P 500 across economic cycles. The price return timeframe we’ll consider is 200 trading days, about one calendar year. The period of time under our microscope: 2003 to the present, which captures the last 2 complete cycles plus the current environment.
Here is the data – 200 day rolling returns for the Russell 2000 minus the S&P 500. When the line goes above zero the Russell has outperformed the S&P over the last calendar year (roughly) and when it is below it has underperformed.
Three points pop out in this graph:
- The COVID Crisis caused the most pronounced US small cap underperformance since at least 2003.
At the worst levels (March 18th, 2020) the Russell’s trailing 200-day price return was 20.0 points worse than the S&P. Prior records were 13-14 points in 2014 and 2019, which were 2 standard deviations (7.5 points) from the mean (0.9 points). By contrast, early 2020’s trailing-year underperformance was almost 3 standard deviations (21.7 points).
- History shows that when the Russell 2000 gets to 10 points of trailing 200-day underperformance, it typically then goes on to outperform the S&P 500.
This is clearly visible in the chart, reading from left to right whenever the line touches negative 10 percentage points: January 2008, October 2011, July – December 2014 (a rougher slog, but still worked out), and January – April 2016.
- The one exception – but it is a critical one – is the last 24 months.
This is also visible in the graph, which shows that the last time the Russell had a winning 200-day streak against the S&P ended in August 2018. The two years since represent its longest losing run since 2003 by a wide margin.
Takeaway #1: while the Russell has beaten the S&P 500 off the March lows (+61% vs. 51%), our 200-day timeframe analysis says not to take continued outperformance for granted. The missing link – what will keep US small caps working – is real cyclical recovery simply because the Russell has no Big Tech exposure but rather heavier doses of Financials (16%), Industrials (15%), Consumer Discretionary (13%) and even Real Estate (6%) than the S&P 500.
Takeaway #2: history clearly says that if you are confident in a real US economic recovery, then there is still time to overweight the Russell 2000. Back to that chart: all the periods of sustained +10-point small cap outperformance (2003, 2006, 2009 – 2011, 2013, 2016) came either off a cyclical bottom (2003, 2009 – 2011) or just after a mid-cycle growth scare (2006, 2013, 2016). Even with the Russell beating the S&P by 10 points from the bottom, there should still be more room to run because of the inherent earnings leverage of this more-cyclical segment of the US equity market.
#2: News that packaging company Ball Corp got a record-low 2.875% coupon on its recent $1.3 billion junk bond offering raised eyebrows on Monday, but this is hardly a representative data point for the health of the US corporate high yield market. Ball is a recession-resistant business, making things like soda cans, and its debt is rated BB+, the last rung before investment grade.
The reality is that the US junk bond market is almost half (44%) rated single B (32%) or CCC and below (12%) using the iShares HYG as a proxy. That’s one of the exchange traded funds that the Federal Reserve has been buying, so it is a relevant measure of this market.
Here are the spreads over Treasuries for single B and CCC-and-below high yield corporate bonds over the last decade. The box shows the latest spreads: 524 bp over for B, 1,235 for CCC-and-below. Neither, as you can see, is anywhere near a record low. For the record, the lows are 336 bp for B-rated paper (in January 2020) and 637 bp for CCC-and-below (in July 2014).
Takeaway #1: the US high yield corporate debt market is far from new low yields – in fact it’s not even back to anything we could call normal spreads. Over the 10-year history shown above, single-B spreads have averaged 503 basis points, 21 bp lower than today. CCC-and-lower spreads have averaged 1,012 basis points, 223 bp lower than today.
Takeaway #2: Federal Reserve buying of junk grade corporate debt ETFs has not yet pushed spreads to anywhere near pre-COVID levels. At the start of 2020, single-B spreads were 357 basis points (167 bp lower than today) and CCC-and-lower spreads were 1,001 bp (234 bp lower than today). Has the Fed’s implicit backstop of the junk market helped tighten spreads? Sure… But pricing in this market is certainly not at record-low yields; in fact, given where the US economy is right now, junk spreads above 10-year averages look very reasonable enough.