The story of the quarter is straightforward. In our previous two client notes, we noted the marked underperformance of the Russell 2000 small cap index relative to the S&P 500, but commented in our Q1 2016 note that the worst of this divergence was likely over. We pointed out that it was driven by two factors: the Russell 2000’s overexposure to energy, and the S&P 500’s overexposure to corporate buybacks. With oil prices recovering and stabilizing since February 2016, and with the volume of corporate buybacks declining in 2016, the Russell 2000 outperformed the S&P 500 by 6% off the early February bottom. See the chart below.
In addition, the S&P large cap low-volatility index also outperformed the S&P 500. This index tends to overweight high dividend-paying stocks. At the start of 2016, the U.S. Federal Reserve Bank (FRB) had signaled it would likely increase interest rates 4 times in the year, but several indicators of economic growth, including inflation, job creation, and wage growth, were low enough to force the FRB to reconsider. Its current messaging is that it may only raise interest rates once or twice, and as a result dividend-paying stocks have outperformed the broader index.
We finally also note the very brief burst of volatility surrounding the UK’s decision to leave the EU. Our market stress indicator correctly remained offensive during the whole episode, and equity market performance quickly validated that call.
In sum, several things went our way this quarter.