By: Mat Lystra, Sr. Research Analyst
Summer in the US means fairs and amusement parks and with them come the ubiquitous "Tilt-a-Whirl" ride. The "Tilt-a-Whirl" spins its riders around on a wave shaped platform, an experience that can turn from exhilarating to nauseating, and back again, in a matter of seconds. Small caps have been on a similar ride in 2016 and the Fed has a hand on the start-stop lever.
The Fed began what was described as a process of "normalization" by raising the target Federal Funds Rate (FFR) at the December 2015 Federal Open Market Committee meeting. However, in the first quarter of 2016 the Fed twice passed on further increases to the FFR. In December the Fed used the term "balanced" to describe the risk outlook for the US economy but has since dropped this language, leading some to speculate about rising downside risk.
Fed committee member Eric Rosengren voted in favor of maintaining the FFR at the March 2016 meeting before proceeding to make a speech warning that ultra-low unemployment rates, brought on by persistently low interest rates, could cause outsized inflation. However, Fed Chairman Yellen's remarks have indicated that she seems willing to risk such a scenario in order to promote wage growth and reduce involuntary part-time employment.
The vacillating guidance from the Fed has contributed to the directional uncertainty in the market. From the third quarter of 2015 volatility has returned to the market with an intensity not seen since the financial crisis. Perhaps the steadfastly accommodative Fed policy regime during the recovery period lulled the market to sleep. And now the market has suddenly been awakened.
The illustration below uses the Russell 2000 Index which measures the US small cap market to demonstrate just how much more volatile the small cap market has become in recent quarters. During the period January 2012 through June 2015 (14 quarters), the Russell 2000 Index had a greater average daily return with a lower standard deviation than during the three most recent quarters from July 2015 to March 2016. We can also see that the difference between the average daily up market and the average daily down market was 36% greater in the latter three quarters than in the prior period.
Average Daily Moves of the Russell 2000
Source: FTSE Russell as of March 31, 2016. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures.
The same trend can be seen if we look at the graph below that illustrates the CBOE's Russell 2000 Volatility Index (RVX) of implied volatility. Using the same two time periods, January 2012 through June 2015 and July 2015 through March 2016, we can see a meaningful uptick in volatility. The average value of the RVX in the recent period is higher and within a larger band of values than that of the prior period.
Average Daily Values of the Russell 2000 Volatility Index (RVX)
Source: CBOE through March 31, 2016. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures.
The Fed's indecisiveness has created an uncertain outlook which is manifested in higher volatility. Small caps are viewed by some commentators as a particularly sensitive barometer of the health of the US economy. When small caps begin to behave like the "Tilt-a-Whirl" ride – up and down, round and round – it is best to buckle your safety belts because higher volatility may be the defining market condition of 2016.
For more on this topic, please refer to the quarterly FTSE Russell Small Caps Perspective Paper.
 Robb, G. (2016). Fed’s Rosengren sees risk that unemployment rate could fall too far, too fast. MarketWatch, accessed on April 18, 2016 at:
 Source: Janet Yellen speech 3/29/2016 https://www.federalreserve.gov/newsevents/speech/yellen20160329a.htm
 For more information on the RVX please visit: http://www.cboe.com/micro/rvx/
© 2016 London Stock Exchange Group plc and its applicable group undertakings (the "LSE Group"). The LSE Group includes (1) FTSE International Limited ("FTSE"), (2) Frank Russell Company ("Russell"), (3) FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, "FTSE TMX") and (4) MTSNext Limited ("MTSNext"). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE TMX and MTS Next Limited. "FTSE®", "Russell®", "FTSE Russell®" "MTS®", "FTSE TMX®", "FTSE4Good®" and "ICB®" and all other trademarks and service marks used herein (whether registered or unregistered) are trade marks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, or FTSE TMX.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for any errors or for any loss from use of this publication or any of the information or data contained herein.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the Indexes for any particular purpose to which they might be put.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this document should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group index data and the use of their data to create financial products require a licence from FTSE, Russell, FTSE TMX, MTSNext and/or their respective licensors.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This publication may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and no member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking statements.