Is a Turnaround in the Stock Market Unfolding?

Over the past month, stock markets worldwide have been in a tailspin.  Meanwhile, the dollar continues to strengthen, which would have a dampening effect on the growth of exports by large cap US companies.   Weakening economies in Europe and Asia are further exacerbating future demand for US products in general.  Fortunately, the Fed's accommodative efforts to keep interest rates low, have continued to support our economy.  The low interest rate environment has also enabled cash-rich large cap businesses to acquire/merge smaller ones that have minimum exposure to overseas markets.  So, unfolding developments could strongly favor small cap stocks in the U.S. in the months ahead.

Small caps are especially attractive now because they have been out of favor.  Over the long term, little companies beat big ones.  Small-company stocks are having a lousy 2014. So far this year, the group, as measured by the Russell 2000 index (RUT), is roughly down 5%, and it trails Standard & Poor's 500-stock index (SPX), which measures large-cap stocks, by a whopping nine percentage points.  One way to take advantage of this imbalance in values is to invest in a wide range of undervalued small cap stocks.

Over the last five trading days, we have already witnessed a turnaround in the Russell 2000.  The Dow and S&P also appear to be approaching a turning point.  While buying now could feel like catching a falling knife, as Warren Buffett has repeatedly advised: it's best to buy when everyone is fearful.

Guggenheim S&P SmallCap 600 Pure Value ETF (NYSE-RZV- $57.52) tracks a fundamentally weighted index of US listed small-cap value companies.  Its proprietary weighting strategy and focus overweights the portfolio with microcaps.  This microcap concentration greatly raises market risk (beta of 1.45) and squashes dividend yield of 0.73%.  RZV's portfolio also has several sector bets. It overweights industrials, information technology, and consumer cyclicals while it underweights financials and real estate.  So, the top three sectors collectively make up over 52% of total assets.  RZV's portfolio is widely spread across 153 securities since each holding accounts for less than 2% of the fund.  RZV's Total Assets exceed $156 million while average daily volume is low at nearly 25,000 shares.
 
RZV's unit price gained nearly 475% over the past five years compared with the Russell 2000, up around 200%, and the S&P 500, up 175%. As of March 2014, it was recognized as the best performing non-leveraged ETF despite its risk of high volatility. Since March, RZV's unit price has been in a flat channel.  With the recent pullback, however, we believe that RZV is positioned to "pop" when the bull market resumes.

Since the fund is non-diversified and not actively managed, the ETF charges 35 bps in annual fees.

Given its narrow segment focus, this ETF would work best as a satellite holding in a diversified portfolio.  We recommend buying RZV with a target price ranging from $68 to $72 within the next 12 months.

Disclosure: Goldman Small Cap Research analysts are neither long nor short these shares but may elect to purchase the stock within the next 48 hours.

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