Is the Small-Cap Market out of Joint? – Chuck Royce and the Royce Funds

"The time is out of joint"

Anyone re-establishing contact with the wider world at the end of June would no doubt be pleased by the numbers that guide the financial and economic parts of our lives. The economy, following a first-quarter stumble in which GDP is estimated to have grown by 0.6%, appears once again to be growing at a faster clip. One could argue that its pace could be livelier, but healthy employment numbers, improving wages, and robust housing and auto markets would seem to promise a quickening in the coming months. Inflation is, for now, not a matter of great concern. Interest rates remain low – and will remain that way on an absolute basis, even with an increase (or two) in short-term rates likely before the end of 2015. And a Fed-led increase in short rates may cause long-term rates to back up as well, which would be bad news for the bond markets, though perhaps not for stocks.

One could find positive developments in the equity markets through the first half of the year –or so it would seem. Returns for each of the major domestic indexes were in the black through the end of June, while a welcome recovery finally arrived for many non-U.S. stocks in the year's first six months. Three- and five-year average annualized returns for the small-cap Russell 2000 Index, the Nasdaq Composite and the large-cap Russell 1000 and S&P 500 Indexes all topped 17%, well above the rolling three- and five-year historical averages for each index. It would appear that we are living through good times for the economy and possibly great ones for equities.

Why, then, have we purloined a line from Hamlet to introduce our own take on stocks in the first half, one in which the titular protagonist warns of a troubling dislocation in the world around him? Some of the reasons are clear enough: Positive results for the first half notwithstanding, global equities were rocked by the highly publicized Greek default late in June. On the second-to-last trading day of the first half, many stocks gave away most, if not all, of their second-quarter gains. Markets in China faced arguably even more significant problems, considering how much larger and more important that nation's economy is to the world compared to that of Greece. Chinese stocks plummeted 30% in the three weeks leading up to our Independence Day, making what seemed like a typical correction in June far more worrisome. A cut in interest rates and more relaxed rules for margin trading –Â both hastily put in place late in June –Â did little to stem the tide of selling.

The small-cap market has thus moved from the tightly correlated markets of 2011-2013 into a new phase of wide divergence and constricted leadership. From our perspective, then, the market is indeed out of joint.

Closer to home, there is the matter of how thoroughly disjointed results were for domestic equities. Large-cap returns, for example, were paltry –Â as can be seen from the table below –brought even lower by the Greek drama that ushered out the month of June. Performance for small-caps and the Nasdaq looked appreciably better, but in each case looks are almost assuredly deceiving. Health Care was by far the dominant sector in every market cap range, from micro to large, that Russell Investments tracks. Yet the rule in the first half seemed to be the smaller –Â and more growth-driven –Â the company, the loftier the results, especially if it was involved in biotech, the industry that has reigned supreme within the Russell 2000 over much of the last two years. This has had the effect of creating decidedly narrow market leadership within the small-cap space. Outside of biotech, strong first-half performances were mostly limited to a handful of other Health Care industries, software companies and a few outliers such as construction materials and tobacco. The small-cap market has thus moved from the tightly correlated markets of 2011-2013 into a new phase of wide divergence and constricted leadership. From our perspective, then, the market is indeed out of joint.

"More things in heaven and earth..."

We have actually been arguing that the market has been disjointed for some time now. Fed policies designed to keep the economy and capital markets above water, which included multiple rounds of QE and keeping interest rates at or near zero, had other, unintended consequences that had an outsized effect in the small-cap market. For example, it became both easy and affordable for businesses to add debt, essentially eroding the risk differential between lower-and higher-quality businesses. Lower-quality and more highly levered companies then began a historically atypical period of outperformance in which our funds mostly did not participate. The Fed's zero-interest-rate policy ("ZIRP") also stoked an intense hunger for yield, which drove up values for bond-proxy equities such as REITs and Utilities, regardless of their underlying quality or profitability, that have only recently begun to correct. These actions also boosted stock correlations and reduced volatility, making it harder to find the kind of mispriced opportunities that have always been our stock in trade.

Finally, there were significant runs for high-growth, nonearning, and more speculative businesses, many with negative EBIT. This continues into the present day with the recent contraction of small-cap leadership, which represents more of a bet on long-duration assets than current profitability. In each of these cases, our more qualitative, risk-conscious approaches have in general kept us away from these areas. While we are confident that this trend will fade and that speculative bubbles will burst, we also understand the frustrations that have built over the last few years as active managers such as ourselves have continued to lag our respective benchmarks.

Equity Indexes as of June 30, 2015 (%)

• Greek drama creates underwhelming results – The Greek default late in June eroded gains – giving equities second-quarter results that more closely hugged the flat line. The tech-oriented Nasdaq Composite was the leader, up 1.8%, followed by the small-cap Russell 2000 Index, which finished the quarter with a gain of 0.4%. The large-cap S&P 500 and Russell 1000 Indexes rose 0.3% and 0.1%, respectively.
• Long-term returns in excess – Both large-cap and small-cap indexes' three- and five-year average annual total returns for the periods ended 6/30/15 were above 17%, well in excess of each index’s historical average.
• Healthy and informed – Health Care and Information Technology were the best performing sectors in the Russell 2000 year-to-date through 6/30/15 – the former led by a wide margin – while Utilities and Materials were the worst performers in the year’s first half.

1 Not Annualized

We have seen enough signs, both economically and in the market, which suggest that stocks are slowly moving back to what we would call their historical norm –Â lower overall returns, higher volatility, and long-term advantages for companies with consistent profits and high returns on invested capital.

Taking stock of the changing environment

So do these challenges mean that something is rotten in the state of small-cap, if only in some of its actively managed precincts? That is the question, more or less, that we have been wrestling with of late. To be sure, we ran the gamut in the first half from disappointment to optimism to frustration as investor preferences moved around. They first showed favor to long-duration assets, then looked, if only briefly, toward consistently profitable and/or conservatively capitalized companies before shifting back again. However, we have seen enough signs, both economically and in the market, which suggest that stocks are slowly moving back to what we would call their historical norm – lower overall returns, higher volatility, and long-term advantages for companies with consistent profits and high returns on invested capital.

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