How would you characterize the third quarter of 2022?
Chuck Royce (Trades, Portfolio): I thought it was an odd and interesting quarter. We saw a robust rally for stocks, which started in mid-June for small-caps, and lasted into mid-August before the overall market shifted downward again. From the beginning of July through that mid-August high, the Russell 2000 Index gained more than 18%. When it fell, small-caps lost 17.5% from the mid-August high through the end of September. Initially, we were hopeful that the rally might last—but we’ve learned over the years that failed rallies, even those with double-digit returns, are often typical during longer bear markets.
An Up and Down Quarter for Small-Caps
Cumulative Returns for the Russell 2000, 6/30/22-9/30/22
Past performance is no guarantee of future results
Francis Gannon: Not long before the rally wound up peaking, we began to suspect that it might not have staying power. We began to analyze its underlying factors and found that it was being driven mostly by short covering and lower quality names, which were pushing multiples higher for both the small- and large-cap indexes. We also found that companies with negative earnings were up 30.4% from the mid-June low through 8/15/22, far outpacing the overall index. While it’s not uncommon for low-quality companies to lead in the initial stage of a market recovery, this bounce seemed to us more like a failed rebound of those stocks that had led during the decline for the first half of the year. From this perspective, the subsequent decline was not very surprising.
Were you surprised that the Russell 2000 Value Index trailed the Russell 2000 Growth Index in 3Q22?
CR: I was somewhat surprised, but having said that, small-cap growth names have been really beaten up over the last two years. Prior to the third quarter, the Russell 2000 Value had beaten the Russell 2000 Growth for seven consecutive quarters, so a counter-trend rally for a quarter isn’t all that unexpected.
Considering these comments, what sense can you make of the extreme up and down nature of the third quarter?
FG: When you see such extreme movement and reversals in a short time like a single quarter, it’s clear that company fundamentals are not driving returns. Macro factors—inflation, rising interest rates, recession fears—have all been at the front of investors’ minds and have so far dictated the direction of stock prices. Until there’s more clarity, I think it’s fair to say that the capital markets will remain pretty volatile. Yet it may not require a substantial piece of positive news. We’ve seen many instances over the years when equity investors responded favorably simply to a lack of bad news.
Do you see rising rates being a problem for stocks?
CR: They certainly have been in the short run. However, I want to clarify that, in my experience, it’s the rate of change that affects equity prices far more than the rate itself. Rates have risen at a remarkably rapid rate so far this year, and that’s what’s contributed to the ongoing bear market. The 10-year Treasury was 1.52% at the end of 2021 and has more than doubled since then, finishing September at 3.83%. That’s not a particularly high rate historically, but it’s an increase of more than 150% over nine months, which was bound to roil the markets. For many investors, this was something they’ve never seen. It’s certainly like nothing we’ve seen since the 2008-09 Financial Crisis.
FG: I think the dramatic pace of rate hikes and the Fed’s decidedly more hawkish stance have been the most consequential developments for investors over the last several months. We’ve had three 75 basis point rate hikes including the Fed’s June meeting, and the Fed has said it intends to keep raising rates until the Fed funds level reaches 4.6% in 2023. That’s a complete reversal from nearly 12 years of near-zero rates and ample liquidity. The result is that all assets are being re-rated. I think the fact that global rates are also on the rise in most developed countries is contributing to the cautious near-term outlook.
With all of this current economic uncertainty, are you more concerned about inflation or recession?
FG: We’re more concerned about a recession, though inflation is obviously a concern as well. To be sure, the debate over recession and peak inflation continues to play out, and the data is still admittedly mixed. The Institute for Supply Management (“ISM”), for example, reported that manufacturing fell to 50.9% in September, signaling the slowest growth in factory activity since the Covid-driven contractions in 2020, yet still in expansion mode. The labor market, while showing some signs of cooling, is still far stronger than it’s been during any previous recession. So while it’s undeniable that the U.S. economy is slowing, there are still enough positive data points to keep the picture unclear.
Are you concerned about accelerating U.S. dollar strength?
CR: First, I think the recent strength of the dollar was a not widely anticipated consequence of rate hikes—especially because the U.S. started raising rates earlier and more aggressively than the rest of the world. U.S. currency has risen more than 15% so far in 2022 as measured by the U.S. Dollar Index, which looks at the dollar relative to a basket of the currencies of our most important trading partners. This is a significant move, but not unprecedented. Our own research has found that returns for small- and large-cap stocks ran very close together following similarly similar sharp increases for the dollar. However, subsequent returns for small-cap value were decidedly strong, particularly compared with those for small-cap growth.
Subsequent 12-Month Returns Following 12-Month Periods With >15% Gains in the DXY Index
From 12/31/78 through 6/30/22
Past performance is no guarantee of future results
Have you seen many downward earnings revisions for holdings in Royce portfolios?
FG: We’ve seen more than we did in the first half of the year, though perhaps not as many as one would expect given the attention that larger companies such as FedEx and Nike have gotten for lowering or suspending guidance. It’s by no means pervasive, though we anticipate seeing at least a few more as we get closer to earnings season in November. In general, companies in industrial areas have reported relatively few while relatively more have come from consumer businesses as well as those with exposure to homebuilding, which have suffered as mortgage rates have been moving up. Additionally, management teams in several industries have talked to us about their challenges around inventory management. They have concerns coming from both sides—supply chain issues are lingering while near-term demand is uncertain. By and large, however, we feel confident in the ability of these management teams to execute effectively through the current host of challenges—be it lower earnings, inflation, or recession—so they can thrive when the economic signals are clearer.
In which areas have you been most actively buying in your portfolios??
CR: In spite of recent volatility and uncertainty, it hasn’t shifted appreciably. In the portfolio teams I’m part of, we continue to lean toward both value and high quality. The decline in the third quarter created select opportunities among small-caps with high returns on invested capital as well as on the value side. A specific area we like is Financials, particularly regional banks, which should disproportionately benefit from rising rates. Many valuations in the sector look attractive as well, which is another reason we like several companies in the sector. We’ve also seen select, attractively priced stocks in cyclical areas such as technology and consumer discretionary. Finally, we think the trend toward re-shoring production is just beginning to create opportunities for small-cap industrial, materials and construction-based companies.
Do you anticipate that small-cap value can therefore regain its leadership over small-cap growth?
FG Yes, I do. Small-cap value has already posted a significant relative performance recovery this year. For reference, as of 12/31/21, the five-year annualized return for the Russell 2000 Value was 9.1% versus a gain of 14.5% for the Russell 2000 Growth—a spread of -5.4% for value. With growth’s significant underperformance so far this year, this spread has contracted substantially3 to the degree that for the five-year period ended 9/30/22, the Russell 2000 Value was up 2.9% versus a 3.6% gain for the Russell 2000 Growth. We expect this contracting five-year spread to ultimately shift in favor of value: Over all five-year monthly rolling average periods since their inception (12/31/78), the advantage was firmly with value, which was up 11.9% versus 8.9% for small-cap growth.
Small-Cap Value Is Recovering Its Long-Term Performance Edge
Five-Year Return Spread for the Russell 2000 Value versus the Russell 2000 Growth
Past performance is no guarantee of future results
With so much uncertainty in the market and economy, what do you think investors should be focused on?
CR: First, I think it’s important to point out that both U.S. banks and consumers are in sound shape—which was not the case in the run-up to the 2008-09 Financial Crisis. This is important because I think the odds of any large-scale systemic issues are low. The foundation of our economy is solid. So while the next several months may be very trying for investors and consumers, I think this is a highly opportune time to buy small-cap stocks.
FG: We understand that this is an anxious time. Yet for this very reason, we believe investors should think about making the commitment to some form of dollar cost averaging. Given the historically cyclical nature of equity performance, markets are being de-risked as they suffer negative returns. And as we have pointed out previously, market rebounds tend to happen quickly. Investors risk squandering a significant amount of their potential returns by trying to time a bottom or sit on the sidelines through a bear market. Stocks have also historically begun to recover before the evidence of a rebounding economy becomes clear—so there are similar risks involved in trying to wait out a recession. Our counsel therefore remains the same as it has been for many years: Follow the old investment adage of being fearful when others are greedy, and greedy when others are fearful.
What is your long-term outlook for small-cap stocks?
CR: I would say that our greatest source of confidence about future returns comes from the peculiar state of long-term small-cap performance at the end of September. For the periods ended 9/30/22, the three- and five-year annualized returns for the Russell 2000 were 4.3% and 3.6%, respectively. These long-term returns were significantly lower than their three- and five-year monthly rolling averages since the inception of the Russell 2000 (12/31/78), which were 10.8% and 10.5%, respectively. Trailing three- and five-year periods have not had returns at or lower than these levels since March 2020 and June 2009.
100% of the Time, Positive 5-Year Returns Have Followed 5-Year Low Return Markets
Subsequent Average Annualized 5-Year Performance for the Russell 2000 Following 5-Year Annualized Return Ranges of 0-5% from 12/31/78-9/30/22
Past performance is no guarantee of future results
FG: We think this is especially important because small cap’s historical return pattern shows that below-average return periods have been followed by those with above-average returns, with a much lower-than-average frequency of negative return periods. Specifically, the Russell 2000 had positive annualized five-year returns 100% of the time—that is, in all 61 periods—averaging an impressive 13.8% following five-year periods of 0-5% annualized returns. So, despite current challenges, we’re confident in the long-term prospects for our asset class.
Mr. Royce’s and Mr. Gannon’s 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.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
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