The Stealth Bull Market For Small-Caps Rolls On by Francis Gannon, The Royce Funds

Co-CIO Francis Gannon discusses small-cap strength in 3Q16 and why, despite potential near-term volatility, history suggests the small-cap rally has room to run.

3Q16 was a strong quarter for small-cap stocks. The Russell 2000 Index (+9.0%) was ahead of both the large-cap S&P 500 (+3.9%) and Russell 1000 (+4.0%) Indexes. Small-cap strength broadened in 3Q16, and 10 of 11 sectors posted positive returns YTD.

History Suggests the Small-Cap Rally Has Room to Run

Stealth Bull Market, Small-CapsSmall-cap rallies typically extend beyond the Russell 2000’s 32.6% increase from its most recent trough on 2/11/16 through 9/30/16. (And at the end of 3Q16, small-caps were just shy of their 6/23/15 peak).

There have been 12 declines of 15% or more for the Russell 2000 since its inception in 1979. The median return for the subsequent recovery period was 98.8%.

[drizzle]Far Short of the Median

Small-Cap Up Market Performance After a Decline of 15% or Greater Since Russell 2000 Inception (%)

Stealth Bull Market, Small-Caps

Small-Caps

1Median includes only full recovery periods

2Interim trough through current 

Additionally, there is pervasive pessimism about the outlook for stocks. We’ve seen persistent outflows from equity funds and heard increasing notes of caution from investors. These are not the signals we would typically expect at or near a performance peak.

Our Outlook: As contrarians, we think we are still some distance from the next small-cap peak. The U.S. economy continues to muddle through with key pockets of solid growth including housing and employment.

To be sure, this comes with the caveat that global risks remain very real, with more than the usual amount of uncertainty, and a correction would not be surprising.


Small-Cap Growth Wins the Quarter, Value Leads YTD

Stealth Bull Market, Small-CapsThe Russell 2000 Growth Index nosed ahead of the Russell 2000 Value this quarter, but value stocks had strong absolute results and still led year-to-date.

Several overlapping areas of small-cap caught up to value stocks, with micro-caps, growth, and low-quality (as measured by earnings, profitability, and returns on invested capital) all flexing their muscles in the form of better quarterly results. Unsurprisingly in a growth-led quarter, cap-weighted returns for the Russell 2000 were higher than equal-weighted returns, which was in contrast to the first half of the year.

Our Outlook: In more than four decades of investment management, we have observed few forces more powerful than reversion to the mean. So we expect the long-running historical advantage for value over growth to reassert itself.

Following a lengthy period of underperformance, small-cap value’s recent leadership is new, having started with the Russell 2000’s peak on 6/23/15. Though we may see short-term performance shifts as the small-cap rally matures, we expect value to outperform for the cycle as a whole.

Small Value Slightly Trails Growth in 3Q16, Leads YTD

Russell 2000 Value and Growth Returns 

Stealth Bull Market, Small-Caps


Widespread Sector Strength As Cyclicals Advance

Stealth Bull Market, Small-Caps3Q16 saw a sharp contrast of its own, this time to previous growth-led periods (most notably to 2015). There was widespread sector strength in the quarter, as there has been in 2016 as a whole. Nine of the Russell 2000’s 11 GICS sectors were in the black in 3Q16, with Information Technology, Health Care, Materials, and Energy making the greatest contributions to quarterly returns.

In fact, cyclical areas such as Energy, Financials, Information Technology, Industrials, and Materials all did well, while the rebound for Health Care was an anomaly among defensive sectors, contrasting relative weakness in Consumer Staples, Real Estate, Telecommunication Services, and Utilities—the last two of which were negative for the quarter.

Our Outlook: We expect small-cap sector strength to remain broad and perhaps keep expanding. Historically, more expansive markets have been better for value stocks.

Widespread Small-Cap Sector Strength 3Q16

Sector Returns and Contributions to Russell 2000, 6/30/16-9/30/16

Stealth Bull Market, Small-Caps

1Real Estate, formerly part of Financials, became a separate GICS sector on 8/31/16.


Passive Outperformed Active in 3Q16

Stealth Bull Market, Small-CapsAs is more common in growth-led markets, small-cap passive strategies were ahead of active management in 3Q16, with the Morningstar Small Blend Category (our proxy for small-cap active management) up 7.1% versus a 9.0% advance for the Russell 2000.

Our Outlook: We expect that active management will shine as small-cap value continues to lead. Our recent study, The Undiscovered Connection, showed that small blend active management has outperformed more frequently in value-led markets.

5-Year Monthly Rolling Returns from 12/31/78 through 9/30/16 (394 Periods), and % of the Periods Morningstar Small Blend Category1 Average Beat the Russell 2000

Stealth Bull Market, Small-Caps

1There were 550 US Small Blend Funds tracked by Morningstar with at least five years of performance history as of 9/30/16

Source: Morningstar

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