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.

Divergence

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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Neuberger Berman’s new options investment team is overseen by Doug Kramer, who joined the firm in November 2015 as Co-Head of Quantitative & Multi-Asset Class Investments (working alongside current Multi-Asset Class Chief Investment Officer Erik Knutzen).

Derek Devens also joins Neuberger Berman from Horizon Kinetics as a Managing Director and senior portfolio manager along with research analysts, Rory Ewing and Eric Zhou. With the addition of this team, Neuberger Berman strengthens its lineup of systematic, outcome oriented investment capabilities.

Previously, Mr. Kramer was CEO of Horizon Kinetics, an investment management firm with approximately $8 billion in assets under management, and prior to that a Managing Principal of Quadrangle Group and a Partner of Goldman, Sachs & Co., where he served as Chief Investment Officer and Head of the Global Manager Strategies Group.

Joseph Amato, President and Chief Investment Officer, Equities, at Neuberger Berman, said “This highly differentiated global options strategy has a demonstrated, long-term track record of delivering attractive risk-adjusted returns. Doug’s leadership and investment expertise is valuable as we serve global investors seeking innovative, outcome oriented solutions.”

Mr. Kramer said of coming to Neuberger Berman, “The breadth and rigor of Neuberger Berman’s investment capabilities is well-suited to serve a wide variety of client needs. I am excited to be working with such a talented group of investment professionals as we help clients achieve their unique investment objectives.”

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Neuberger Berman has experience working with clients who manage significant funds in-house. These clients benefit from the knowledge transfer and customized investment solutions of a multi-asset class strategic partnership. Current clients of this type range from sovereign wealth funds to several leading U.S. public and corporate pension plans.

In this new role, Mr. Knutzen will drive the asset allocation process on a firm-wide level and create related client content for strategic partnerships and multi-asset class solutions while joining in portfolio management on a number of mandates. “Erik’s skills and experience complement our existing client partnership capabilities,” said Joseph Amato, President and Chief Investment Officer, Neuberger Berman. “Adding a seasoned, senior multi-asset class investor to an already deep capability at the firm helps Neuberger Berman deliver more insight, ideas and peer-to-peer investment experience to these important relationships.”

Mr. Knutzen joins from NEPC, LLC where he has served as chief investment officer since 2008. As CIO, Erik oversaw a group of more than 45 investment professionals, including dedicated research teams focusing on Alternative Investments, Traditional Strategies and Asset Allocation.

In this role, Erik led investment strategy development including market assessment and outlook, and communication of key themes and best ideas for NEPC’s client base with, collectively, more than $800 billion in assets under advisement. He has over 25 years of experience in the financial services industry, including nine years at Putnam Investments. During his time there, he was a member of the global asset allocation group, led the institutional portfolio management team with 15 portfolio managers, and served as a senior leader of the firm’s international business.

Erik has been awarded the Chartered Financial Analyst and Chartered Alternative Investment Analyst designations.

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