A Typical Rebound in Atypical Times
Global equity markets enjoyed a remarkable recovery in 2Q20, coming back strong following mid-March bottoms that resulted from COVID-19-driven lockdowns. The small-cap Russell 2000 Index rose 25.4% for the quarter, going from its worst quarter ever in 1Q20 to one of its three best quarters since its inception more than 40 years ago.
In spite of ongoing volatility and considerable economic anxiety, stocks behaved in a fashion consistent with historical rebounds in recessionary periods. The global health crisis was undoubtedly an unprecedented cause for the market’s decline, but the subsequent pattern for equities was very much in line with history: Micro-caps beat small-caps, which in turn outpaced large-caps. The recurrence of this familiar recovery pattern gives us a measure of confidence amidst the ongoing short-term uncertainty.
Mirror Images: 2020 Quarterly Returns by Market Cap
2Q20’s gains were nearly the reverse of 1Q20’s losses
Past performance is no guarantee of future results.
There were additional examples of the reversal from 1Q20 to 2Q20. The sector leaders and laggards reversed as well, with Utilities moving from first to worst while Consumer Discretionary traveled in the opposite direction, going from second to the bottom to the top-performing sector.
Familiarity in Strange Days
We are also encouraged that the anomalies in the current period have so far been limited first to the global health crisis that precipitated the bear market and second to the extraordinary speed with which shares both fell and rose. In addition to the historically familiar market cap array of returns, other factors, including cyclicality and perceived riskiness, performed as we would have expected in 2Q20: cyclicals beat defensives, higher-leverage stocks outperformed lower-leverage issues, low quality (as measured by return on equity) edged high quality, and non-dividend payers outpaced dividend payers.
In the early days of the decline, investors seemed to be most worried about the state of the global economy and financial system, the latter grounded in painful memories of the Financial Crisis. By providing ample liquidity, the Fed worked to quickly defuse the latter concern, which helped the market to begin stabilizing in mid-March. This was followed by economic news that, while not positive, was far less worrisome than had been anticipated, and this drove the recovery from roughly mid-May on. May’s change in investor perception keyed a leadership shift in small-cap as cyclicals took over from defensives from that point.
Intra-Quarter Leadership Shift: Cyclicals vs. Defensives
Russell 2000 cyclicals trailed early but came back strong to outpace defensives in 2Q20
Past performance is no guarantee of future results.
The strength of the recent upswing has given some investors pause. They wonder how stock prices can be climbing when the economy still appears to be in rough shape. Yet this is also historically consistent. The market typically looks forward, being more focused on the days ahead than on the present. This was the case in 2009, when stocks bottomed in March while the recession did not end until June of that year.
Whither Value?
One curious exception to the otherwise historically conventional market behavior in 2Q20 was value, which underperformed significantly across the market cap spectrum from micro- to large-cap. Value lost ground to growth during the recovery as well as in the decline. Recent underperformance extended disappointing relative results for value over much of the past 10 years, 2016 being the exception.
This persistent underperformance has reversed a pattern that has held since the 1980s, when value routinely outperformed growth over three-year or longer periods. Some of this underperformance can be explained by unfavorable environments for value stocks, specifically the low interest rates and slow, steady economic growth that have tended to provide tailwinds for growth stocks and headwinds for value. More fundamental reasons have also made an impact as the asset-heavy business models that have greater weighting in the value universe remain out-of-step with an economy in which rewards are increasingly bestowed on ideas and/or asset-light businesses. Yet while the outlook for the overall small-cap value universe is mixed, there is a selection of very attractive undervalued opportunities for active managers.
A Look Ahead: Divergence = Opportunity
Also of interest is that the Russell 2000 remained well below its August 2018 peak—by 14.9%—at the end of June while the Nasdaq established new highs. We think this divergence is significant in that some investors may be hesitant to invest in small-caps in the mistaken belief that the asset class has peaked. While other parts of the market look overheated, small-cap does not, particularly when one looks at individual small-cap companies.
A comparison with the recovery from the two most recent steep small-cap declines in 2000-2002 and 2007-2009 may also be helpful. In the subsequent two-year periods following the trough in those two declines, small-caps advanced 80.4% and 145.6%, respectively. These gains significantly exceed the 46.0% return for the Russell 2000 from the 3/18/20 low through the end of June. Based on both history and the current market cycle, therefore, it looks as though small-cap stocks have room to run.
Small-Cap’s Bear-Market Rebounds
Returns for the Russell 2000 have been historically strong coming out of significant bear markets.
Past performance is no guarantee of future results.
Notwithstanding our optimism about the prospects for select small-caps, we also expect volatility to remain elevated in the current period of intensified uncertainty. The average daily VIX has stayed north of 30, a high historical level, in each of the last four months. This volatility may take the form of occasional dramatic spikes based on headline news relating to COVID-19 or economic data, as has been the pattern over the last several months. Increasing attention on the November elections and their consequent potential policy shifts—especially regarding the regulation of mega-tech giants such as Facebook and Google—are also likely to create increased volatility in the months ahead.
Foggy Short-Term Views versus Long-Term Clarity
To be sure, the short-term outlook over the next six to nine months is uncommonly occluded. It’s therefore not surprising that so many people seem to be investing based primarily on headline news, not appearing to give much thought to any period beyond the end of the year.
Long-term thinking in a short-term world has traditionally offered disciplined active managers an advantage over the ensuing three to five years. It’s also important to remember that small-cap has enjoyed positive returns over three-year or longer periods the vast majority of the time. As measured by the Center for Research into Security Prices, small-caps have had positive results in 88% of the rolling monthly three-year periods and 95% of rolling monthly five-year periods ended 5/31/20 since 1945.
Not as Risky as You Think
% of Positive Monthly Rolling Return Periods for Small-Cap Stocks from 12/31/45-5/31/20
Number of monthly rolling periods where the Small-Cap CRSP 6-10 has a positive return: 3-Year (756 out of 858), 5-Year (793 out of 834)
Number of monthly rolling periods where the Large-Cap CRSP 1-5 has a positive return: 3-Year, 88% (759 out of 858), 5-Year, 93% (775 out of 834)
Past performance is no guarantee of future results.
If we assume for the moment that the small-cap low in March 2020 holds, we see considerable potential for the strongest, best-managed small-cap companies to grow stronger coming out of the current globally challenging situation and enjoy success in the years ahead. This includes companies involved in e-commerce, the Internet of Things, and work-from-home technology, often in semiconductors and related components businesses. We also like companies that manufacture RV and boating components, which are benefiting from changes in travel and vacation habits where physical distance is needed. Additionally, we see companies involved in M&A and corporate restructurings as very well positioned for an acceleration of growth over the intermediate term.
Recent volatility and the uncertain outlook might cause investors to hesitate before investing in small-caps. In contrast, we would suggest looking forward to the years ahead. While the shape and timing of the recovery are unknown, we believe that small-caps are likely to have higher profits—which have historically been reflected in higher stock prices. Investors with the discipline and patience to invest in small-caps now could be rewarded in the years to come.
The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partners, and, of course, there can be no assurances with respect to future small-cap market performance. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
