The rally occurs in the face of a serious downturn in the housing market. While there is a broad consensus that this is the worst downturn the sector has seen in a decade, the depth of the impact is still unclear, as is the longer term effect it will have on consumer spending. Many asset managers have been positioning themselves to benefit from an anticipated shift of growth impetus from the consumer to business spending, and business investment has indeed been robust, rising at an annual rate of 8.6 per cent in the third quarter. Consumer spending remained fairly strong as well, rising at an annual rate of 3.1 per cent.
US equity performance across all capitalisations continues to be led by value style stocks, as has been the case since 2000, with the long awaited shift in leadership to the growth style yet to appear. Another feature of recent market performance has been an extended rally in smaller capitalisation names, again led by value – style stocks. In 2001, with valuations across all small cap stocks at cyclical lows following the bursting of the bubble, the stage was set for a rally in the small cap segment propelled by both relative valuations (small caps had an average price/earnings ratio of 15 in 2001 while larger cap were around 25), and a cyclical recovery in earnings growth. The combined effect of this style and capitalisation preference has taken small cap value stocks to high valuation levels relative to other market segments and to their own historical norms.
After the price improvement in smaller caps over the last few years, on an absolute valuation basis, large caps in general appear more attractive, and indeed have outperformed small caps from January to date (mid-November 2006). However, given the historically faster growth of the small cap segment, the two segments are arguably roughly on a par from a relative valuation perspective. A wider gap has emerged at this point between the two style segments in the small cap space, with price/earnings ratios for the Russell 2000 Value Index well above their 20-year average, while those for the Russell 2000 Growth Index are near 10-year lows. In addition to a relative valuation argument, small cap growth stocks may be somewhat less cyclical than value names as they tend to represent more innovative and sometimes less capital intensive industries, and so may be less impacted by a slowing economy.
Scott Ayres, senior product manager, actively managed equities, Northern Trust Global Investments.
