SLYV - SLYV: Time To Rebalance (Rating Downgrade)

2023-08-22 06:27:33 ET

Summary

• Cyclical risks have resulted in higher risk attribution for the SPDR® S&P 600 Small Cap Value ETF.
• A historical regression paired with resilient inflation and a softening credit market suggests small-cap value stocks might flatline for the time being.
• A positive output gap is encouraging to see. However, it implies a "higher for longer" interest rate environment, which could lead to an obstacle for small-cap value stocks.
• Weakening risk-return metrics suggests SLYV's active risk-return benefits are diminishing.

This article provides an update on our outlook on the SPDR® S&P 600 Small Cap Value ETF (SLYV) . The asset is highly cyclical; therefore, frequent revisiting is warranted.

In our view, the SPDR® S&P 600 Small Cap Value ETF's key influencing variables have shifted since our latest coverage, which is why we decided to update our readers on the asset's prospects.

Whether you're a long-term trend investor or a cyclical investor, considering cyclical asset weights in your portfolio is pivotal, as it can make a substantial difference if you're seeking an edge over other investors.

Herewith are our recent findings relating to the SPDR® S&P 600 Small Cap Value ETF.

Factor Analysis

A quick look at investment factors shows that small-cap value stocks have underperformed most other style-based categories since the turn of the year.

Our previous analysis of the SPDR® S&P 600 Small Cap Value ETF forecasted that small-cap value stocks would surge as the economy bottoms out and expansionary monetary policy initiates.

Our prediction clearly didn't pan out as SLYV experienced a total return of merely 0.98% (at the time of writing this article) since our publication. As will be explained later in the article, there were unforeseen reasons that led to our misprediction, which embodies the uncertain economic climate we have lived in since the emergence of Covid-19.

Inflation Is Throwing SLYV ETF's Cyclical Outlook Into Question

Much of small-cap stocks' recent battles are likely due to U.S.'s inability to curb inflation. The nation has sparred with inflation for much of 2023, and July's numbers affirmed the battle.

Unfortunately, risky assets such as small-cap stocks are unlikely to outperform the market until inflation diminishes, as they generally require expansionary monetary policy and a steepening yield curve to surge. We believe rising short-term yields and restrictive monetary policy will continue to phase out bullish prospects for small-cap value stocks.

Another issue is the credit market. Receding interest coverage ratios provides an additional indication that the economy has likely topped and is yet to enter a contractionary phase. Pressure on the credit market usually spells trouble for risky assets such as small-cap stocks, which presents additional worries for SLYV's investors.

On a lighter note, the U.S. output gap is in positive territory at 1.26%, which is higher than its historical average of -0.62% . A positive output gap suggests the economy is living up to its potential, with actual GDP reaching potential GDP due to high labor productivity and sound capital stock allocation. However, the positive output gap might mean that the U.S. interest rate will remain higher for longer in an attempt to cool down the economy. Thus, presenting a cyclical headwind to the SPDR® S&P 600 Small Cap Value ETF.

Below is a regression analysis we discussed in our previous article about SLYV. It shows how small-cap ("size") stocks perform in various stages of the economy. Our argument until now claims a "slowdown" is en route, which is why negative rhetoric is echoed throughout.

The Fund's Risk-Return Attribution

Many of you might be asking why we haven't looked at some of SLYV's constituents as yet. Well, the answer is that this ETF holds in excess of 450 securities, with its top 10 holdings constituting merely 7.58% of the portfolio exposure. Therefore, I am willing to bet that this ETF's security-specific risk is fully diversified, which is why a style-based analysis (as we did in the previous sections) coupled with an observation of risk-return attribution is the best way to assess the SPDR® S&P 600 Small Cap Value ETF's prospects.

The diagram below, which can be enlarged if clicked on, shows the ETF's key risk-return measures. A discussion about the metrics can be found beneath the diagram.

Since our latest analysis, the SPDR® S&P 600 Small Cap Value ETF's Sharpe Ratio has remained unchanged, suggesting a near identical excess return (over the risk-free rate) per unity of volatility. However, SLYV's Sortino Ratio has improved to 0.80 from a previous 0.78, suggesting an enhancement in excess returns relative to downside risk.

Unfortunately, SLYV's active return has weakened to 3.17% from its previous 3.62%. This suggests that although the ETF continues to outperform its benchmark on a moving-average basis, its excess returns are weakening.

Lastly, the fund's Information Ratio has decreased to 0.30 from 0.35 recorded in our latest coverage. Lower active return paired with a higher tracking error has caused a softer IR ratio. Therefore, implying softening benchmark-relative risk-adjusted returns since our latest coverage.

Final Word

Based on our latest analysis of the SPDR® S&P 600 Small Cap Value ETF's key variables, we decided to downgrade the asset to a Hold from a Strong Buy. Although SLYV's long-term features remain in check, we think investors would be wise to invest moderately instead of using the ETF as a conviction play.

Consensus: Hold rating assigned with a six-month holding period in mind.

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