Neuberger Berman CIO weekly perspectives: Hidden value


Erik Knutzen

Lagging small caps indicate that, beneath the record-high S&P 500, all may not be as placid as it seems

We are currently gathering our thoughts for our latest quarterly Asset Allocation Committee Outlook. You can see a preview of the ideas here, the full publication will be coming soon, and we look forward to welcoming you to the webinar on July 16.

In the meantime, it’s worth noting that the theme that has caught our attention this quarter is the way that what we see on the surface can conceal both the complexity and opportunity that lies beneath.

For example, we think the doldrums in inflation data—which is scaring central banks into renewed dovishness and bond markets into negative yields—conceals a more interesting story that is becoming evident in leading indicators. They may be suggesting that consumer prices are reaching a trough just as the Federal Reserve gets ready to cut rates.

Similarly, in equity markets, the story most people are focused on is the advance of the S&P 500 Index to a record high, within touching distance of 3,000 points. But we think there is a more interesting story going on underneath.


A near-20% gain in the value of the U.S. stock market in the first half of the year might reasonably be taken as a sign of investors’ optimism and keen appetite for risk.

Over that time, however, U.S. small-cap stocks, as measured by the Russell 2000 Index, have risen by 16.5%. In a “risk-on” environment, riskier smaller companies would normally rally more than large caps.

Look back over 12 months, and the picture becomes even starker. The S&P 500 is up around 12%, but the Russell 2000 is still down by almost 5%.

Can valuations explain this? Not really. The Russell 2000 trades on a higher forward price-to-earnings multiple than the S&P 500, but that is normal. More importantly, the S&P 500’s multiple is two points higher than its long-term average while the Russell 2000’s is just half a point higher.

This divergence in performance appears to have more to do with investor sentiment. We think that’s interesting: It shows how record-high levels for the equity index can coincide with quite cautious, even slightly bearish, positioning within the market. What’s on the surface can conceal the complexity beneath.

We find similar patterns all over equity markets. Whether it’s regions, sectors, style or high-beta stocks versus low-beta stocks, everywhere we look we find the “risk-on” assets lagging the “risk-off” ones.

And then, of course, there’s the big one: the puzzle of how we can be breaking records on both the S&P 500 and the value of negative-yielding bonds at the same time. A major part of the answer is revealed by this underlying caution inside equity markets.

A Turn in Investor Sentiment

Are these potential value opportunities?

From a historical perspective, when large caps have opened up a 16- to 17-percentage-point lead over small caps in the past, that gap has tended to revert back to the mean. Sometimes this is due to small caps outperforming, sometimes to large caps underperforming, often both.

Looking forward, we think this is why it’s interesting to see an apparent stabilization, and possibly a bottoming out, in some of the more leading growth and inflation indicators (more on that in the forthcoming Asset Allocation Committee Outlook).

Should this coincide with the Fed and other central banks loosening policy, it could mark a turn in investor sentiment, with the likely beneficiaries being those asset classes and sectors that have lagged over the past 12 months. While we would always caution against tracking a problematic benchmark such as the Russell 2000, we see U.S. small caps, actively managed, as one of the key parts of that lagging cohort.

Our Asset Allocation Committee has eased toward being more neutral on equities in its overall views. As last week showed, economic releases are likely to be continued in a seesaw pattern: Business surveys out of China and Europe, and especially German manufacturing data, came in low even as the U.S. jobs report indicated still-robust growth. Beneath the placid surface, however, we see opportunity to take advantage of market complexity.

By Erik Knutzen, Chief Investment Officer—Multi-Asset Class

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