The reconstitution of the Russell indexes each year in June represents one of the largest short-term drivers of demand for specific U.S. equities. Advanced trading strategies of market participants from hedge funds to retail investors focus on accurate prediction of membership and subsequent demand shifts. Savvy investors familiar with the process can predict which stocks might move in or out of indexes, though the process is not as simple as identifying the 2,000 largest companies on the market. Analysis of pricing trends among stock styles and sizes can help investors identify potential beneficiaries or laggards as the indexes are reconstituted.
Each year in May and June, the Russell Indexes release an updated list of the constituents for their various indexes, notably the Russell 2000 and Russell 1000. Many exchange-traded funds and mutual funds are constructed to track these indexes, so official index rebalances force these funds to transact large volumes of stocks that move in or out of the index. This drives major changes in demand for stocks, generating significant volatility. The Russell U.S. index methodology takes into account market capitalization, home country, exchange listing eligibility, the price per share, share availability, trading volume, and company structure.
Small and Mid Cap Valuation
Analysis of a basket of valuation metrics indicates that small- and mid-cap stocks are trading at a significant premium to their 30-year historical averages as of June 2016. The small-cap forward price-to-earnings ratio of 16.7 is 9% above the 15.3 historical average, though it reached a cycle high of 19.3 in 2013. Small caps also trade at a 3% premium to large caps, which is two percentage points off of the historical average and 28 percentage points below the cycle high. Lower relative growth expectations appear to be a significant factor in relative valuation, as PEG falls above the historical average. Mid-caps trade at a 3% premium to their smaller counterparts on a PE basis at 17.5, reversing a historically normal discount. It is also important to note that mid-caps are 8% more expensive than mega-caps, far below the 27% peak premium but still above the parity exhibited historically.
The Price of Growth
Valuation analysis by Bank of America Merrill Lynch, the corporate and investment banking arm of Bank of America Corporation (NYSE: BAC), suggests that the pricing of growth is attractive relative to historical levels. Growth-style companies generally trade at a premium to value-style stocks, but the premium is narrow relative to historical levels for both small caps and mid-caps, which stand at 15% and 12%, respectively. These mark the narrowest spreads since 2010. Small-cap value stocks outperformed growth stocks year-to-date, conditions that have only held in three years of the preceding decade. This indicates that the market is anticipating slower growth than analysts are forecasting. Growth stocks had outpaced their value counterparts since 2009, riding a wave of improving economic conditions and loose monetary policy. As of June 2016 had brought expectations for Federal Reserve rate hikes, turmoil in energy and commodities markets, and weakness in certain major global economies. These conditions catalyzed investor desire for high-quality, low volatility stocks as risk tolerance waned. Rich valuations for high-flying technology stocks also pushed investors toward energy and financial stocks that traded at discounts to book value.
Implications for Rebalancing
Russell index constituency is based on several factors, though market capitalization is the primary determinant. Strong performance among mid-cap stocks could prevent small caps from moving into higher indexes in large numbers. Value stocks might also be more likely to move into indexes, while growth stocks on the margins are more likely to be dropped. Growth stocks that fall out of the indexes are particularly vulnerable because these are typically more volatile. Investors can also expect companies that have suffered due to global macroeconomic volatility to be at risk of exclusion. Basic materials and energy companies are particularly at risk, since taking raw material prices have wreaked havoc on their bottom lines.