2Q19 Small-Cap Investment Review And Outlook
article 07-01-2019

2Q19 Small-Cap Investment Review And Outlook

Small-cap stocks lagged large-caps in 2Q19, but here’s why a rebound may be coming.

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2Q19—Riding the Small-Cap Seesaw

Small-cap investors experienced a seesaw ride in 2Q19—lots of motion with little overall progress. Bullish months in April and June bookended a bearish May, leading to a modest 2.1% positive return for the quarter.

From our perspective, the second quarter’s muted performance for small-caps appears reasonable, especially following a very strong 1Q19 in which the Russell 2000 Index increased 14.6%. It’s not uncommon for a pause to follow that kind of dramatic upward move as the market digests the prior advance.

Additionally, the second quarter’s largest drawdown of 9.1% was very much in line with what small-caps have done historically. The median intra-year decline for the Russell 2000 over the past 25 years was 14%.



Small-Caps Lag Large-Caps, But Will That Reverse?

U.S. equity performance for 2Q19 trended lower the further down the capitalization range you traveled. Large-caps, as measured by the Russell 1000 Index, rose 4.2%, followed by gains of 4.1% for the Russell Midcap, 2.1% for the Russell 2000, and 0.9% for the Russell Microcap. The strength of larger stocks looked to us to be driven largely by the ongoing effects of declining interest rates. The relative returns for small-caps vs. large-caps have historically been stronger in rising interest rate periods and weaker in falling rate periods.

We witnessed a relatively rare divergence over the past 12 months: small-caps declined and large-caps advanced. In the most recent one-year period, the Russell 2000 declined by 3.3% while Russell 1000 advanced 10.0%. This divergence has occurred in only 16 out of 229 monthly rolling 12-month periods over the past 20 years (that’s 7% of the time!).

In the 12-month periods that followed these divergences (14 had subsequent periods), small-caps outperformed large-caps more than 92% of the time (13/14 periods). We think there’s a good chance that this historical pattern continues.



Cyclicals Outperform, Despite Economic Anxiety

We were very pleased to see small-cap cyclicals outperform defensives for the quarter. This outperformance was noteworthy in that it took place in the face of increasing caution about the pace of economic growth, as well as declining rates, which historically have been better for defensive stocks.

Industrials led overall while two other cyclical areas—Financials and Information Technology—finished third and fourth. Utilities, the most bond-like sector in the small-cap index, placed second, which is to be expected in a quarter with such a large interest rate decline.

Cyclical sectors also dominated the laggards as Energy and Communications Services were the worst two performing sectors. Energy stocks declined along with the price of oil, seemingly in sympathy with heightened anxieties about economic downturns, while all industries within troubled Communications Services posted losses in the quarter as the entertainment industry recorded the largest decline.



What’s Next? Investors May Be Surprised

Markets often do what’s most surprising to most investors. Today, given the widespread concerns about slowing growth, increasing trade tensions, and extended economic cycle, the most surprising outcome might be a rally. Here are the four factors that we view as favorable: 

four-favorable-factors

Low Inflation: Environments with low inflation have historically been very positive for all financial assets—and particularly positive for stocks.

Modest Valuation: In contrast with large-caps, and based on a variety of measures, small-cap valuations are close to their historical average. Even better, small-caps are cheap compared with their historical spreads to bond yields.

Moderate Growth: We see an important distinction between a slowing, but still growing, economy and one that’s contracting. Based on our company research, we see the U.S. squarely in the first of these two conditions. We also think that the most recent quarter might be the bottom in year-over-year earnings growth. Second-half earnings prospects for many of our holdings seem promising given the relatively weaker third and fourth quarters of 2018 to which they’ll be compared.

Increasing Liquidity: Much of the discussion about the recent dovish pivot for the U.S. Federal Reserve, as well as the ECB, has been centered on expectations for lower rates. We think that central banks will likely also increase financial market liquidity. The relevance of this for small-cap investors is that periods of low economic growth accompanied by increased liquidity have historically led to financials assets being bid up.

With so much attention on negative macro issues—such as the slowing rate of global growth, tariff concerns, and trade wars— we think investors may be missing some of these favorable factors that we see from our position as small-cap specialists.

Is a surprise coming? Stay tuned.

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Important Disclosure Information

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization-weighted. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 Index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

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