Risk at record lows but small caps become much riskier

Week of November 9

In the year following the US presidential vote, major indices in the US hit all-time highs, as equity risk plunged to records lows, and small caps became much riskier than large caps. The Russell 1000 marched almost straight up since November 8, 2016, recording a cumulative one-year return of about 23%. The Russell 2000 also shot up immediately after the elections, and while it basically stalled out from November to July, and fell in August, its cumulative one-year return was above 25% as of last Thursday.

Short-term risk declined sharply for both indices during this period, as measured by Axioma’s fundamental short-horizon US4 model. Risk halved for the Russell 1000 since Election Day last year, reaching 5.5% last Thursday—at least a 35-year low. Forecasted risk for the Russell 2000 declined about 40% over the past 12 months, to 8.7% last week. Since the risk of Russell 1000 has fallen more rapidly, it made the Russell 2000 much riskier relative to the Russell 1000. The ratio between Russell 2000 and Russell 1000 short-horizon risk forecasts reached a decade-high peak of 1.76 in May, while the ratio of the medium-horizon forecasts rose to its decade-high peak of 1.67 in June. Both have since receded but remain elevated.

Risk spreads between statistical and fundamental forecasts for the Russell 1000 narrowed but remained positive at both the short and medium horizons. Positive risk spreads indicate extra risk picked up by the statistical models that may reflect potential changes in the risk regime and/or the emergence of non-traditional factor risk sources. US medium-horizon statistical forecasts have exceeded their fundamental counterparts for the past 12 months, with the spread reaching an eight-year high of 2.1% in the beginning of April. The medium-horizon spread has since narrowed, and now stands at a modest 0.7%. The short-horizon spread climbed rapidly after November 8th, 2016, and peaked at 2.6% in January of this year, before it began to decline. The short-horizon US statistical and fundamental models were in agreement at the end of August and September, and the spread even became negative for a short period before ticking up above zero in October and ending at 0.4% on Thursday.

Information Technology was the big winner among the sectors in the Russel 1000, with cumulative trailing-year returns of 40%. The second and third best performers were Financial and Materials, with 32% and 26% cumulative one-year returns, respectively. Telecommunications was the biggest loser, recording negative cumulative returns of -3%. Energy was the worst performer for most of the trailing year, but after hitting a cumulative return of -9.5% in August, it started recovering and ended last week at 4%.

All sectors in the Russell 1000 saw their risk decline over the past 12 months, with the exception of Telecommunications. The risk of Telecommunications decreased slightly until July end, when it started rising, and was 16% last Thursday (about 130 basis points above the level of a year ago). The riskiest sector throughout this trailing year was Energy, its risk forecast finishing last week at 17%. Financials was the third riskiest at 12%. Info Tech’s risk was in the middle of the pack, and Consumer Staples and Consumer Discretionary were the least risky sectors in the Russell 1000, with risk forecasts of 7% and 9%, respectively, last Thursday. However, Info Tech brings the highest contribution to the Russell 1000 risk—above 31%—about seven percentage points higher than its weight in the index.

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Melissa Brown, CFA

As Managing Director of Applied Research, Melissa Brown generates unique insights into risk trends by consolidating and analyzing the vast amount of data on market and portfolio risk maintained by Axioma. Brown’s perspectives help both clients and prospects to better understand and adapt to the constantly changing risk environment.