At Royce, our expertise lies in evaluating and understanding companies—their value, quality, and prospects. We claim no special skill in predicting economic, political, or strategic outcomes. We are, however, keenly aware that investors have questions about the economy and how it may affect our chosen asset class of small-cap stocks. This is particularly relevant in today’s world, where slow economic growth has been somewhat paradoxically accompanied by robust stock market returns.
This has resulted in investors naturally wondering about what may be next for small-cap stocks. In pondering this question, we first looked at small-cap performance in previous slow-growth economic periods. After emerging from the deep recession in 2008-2009, the U.S. economy has been growing, albeit at a sluggish pace. During the three years following the recession (2010-2012), output grew at an average annual rate of 2.13% according to World Bank Data.1
While no one knows for sure what the future will bring, many experts are predicting that financial markets are likely to remain volatile over the next few years, with growth in the U.S., as well as over much of the rest of the globe, remaining subdued. That said, there are a few things that give us confidence in our asset class.
Leading During Periods of Slower Economic GrowthAlthough it may seem counterintuitive, research shows that small-cap stocks have historically outperformed large-caps in periods of slower economic growth. Looking at data provided by the World Bank,1 in the 34-year period from 1979 through 2012, annual GDP growth was less than 3% half of the time. During those 17 years of slower growth, small-caps (as represented by the Russell 2000 Index) outperformed large-caps (as represented by the Russell 1000 Index) in 11 of those years, or nearly two-thirds of the time.
The excess return for small-caps over large-caps during those years of outperformance ranged from 1.2% to 17.4%, with an average excess return of approximately 8.3%. Notably, small- caps also outperformed large-caps in four of the five years in which GDP growth was negative during the same 34-year period.
The table below shows all calendar years from 1979 to 2012 where GDP Growth was less than 3%, the corresponding performance of the Russell 2000, the Russell 1000, and the index performance spread.
After the Rally, Then What?With the U.S. Federal Reserve2 forecasting moderate GDP growth of 2.3% to 2.8% for 2013 and 2.3% to 2.5% over the longer run, investors may question how well small-caps can do against a backdrop of anemic growth when they have already —in what appears to be a disconnect with the broader economy—roared higher. There has been a significant rally for equities this year, most notably in small-caps, with the Russell 2000 returning 27.7% year-to-date through the end of 2013’s third quarter. Can the rally last, or is a small-cap sell-off on the horizon?
While some are concerned that market sentiment has run ahead of fundamentals, others would argue that equities remain a generally accurate predictor of economic prospects. Seeing some wisdom in each of these points, we reviewed the data to see what context history might provide.
We looked at every month-end period since the 1979 inception of the Russell 2000 in which the index gained 25% or more for a nine-month period. There were 73 such periods, including the current year-to-date through September 30, 2013 period, which was up 27.7%. We then examined how the index performed in the ensuing 12-, 24-, and 36-month periods.
Distribution of 12-Month, 24-Month, and 36-Month Annualized Returns of the Russell 2000 Following a Nine-Month Return Period Where the Index Returned Greater Than 25%
68% OF ALL ENSUING 12-MONTH RETURNS ARE POSITIVE
We found that for all of the 12-month periods following a nine-month rally of this magnitude, the Russell 2000 continued to post positive returns 68% of the time; in 48% of the periods the 12-month return exceeded 10%; and in 24% of the periods ensuing 12-month returns were greater than 20% for the small-cap index.
Opportunity Ahead?Although past trends may not indicate future results, history does show that the current rally may still have legs; it is possible for small-caps to continue delivering positive returns in the near-to-intermediate term.
In fact, the combination of slow economic growth and strong small-cap performance is neither uncommon nor new. Moreover, we find the historical results encouraging. Since the inception of the Russell 2000, there have been 17 years in which GDP grew at less than 3% per annum. In 10 of these 17 years, the small-cap index was up 15% or more; in six of those 10 years, it advanced 25% or more; and in three of those 10 years it rose more than 35%.
So as the seemingly mismatched couple of mixed economic indicators and strong equity results continues to baffle investors and humble the ablest prognosticators, we remain confident in the case for equities, and specifically smaller companies.
While we are encouraged about the future return potential of smaller companies, we believe that an approach that focuses on high-quality small-cap companies selling at attractive discounts offers the best potential path to above-average long-term performance.
Important Disclosure Information
The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 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. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
1 World Development Indicators, http://data.worldbank.org/country/united-states
2 Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, June 2013, www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130619.pdf