Co-CIO Francis Gannon discusses the dramatic reversals in the small-cap asset class and how they could impact 2017.

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Small-Cap Industrials
Image source: Wikimedia Commons
Small-Cap Market

The small-cap market saw three major reversals last year, in what was a very dramatic year within the small-cap asset class. We had the completion of a bear market in February, the lows of the market in February 11.

And then we went onto what turned out to be a quite dramatic rally in the market that was exacerbated in the post-election environment.

The question, I think, that we all have going into 2017, is will the rally continue? And I think people have to recognize that while many investors are focusing on the S&P in general, and the fact that we haven’t seen a major decline within the S&P 500 for a period of time, the Russell 2000 has actually had two distinct cycles since the bottom of the market in March of 2009, the most recent one just completed in February of this year, where we had a bear market decline of over 26 percent.

If you go back and you look at the history of the Russell 2000 going back to 1979, there have been 12 declines in the market of 15 percent or greater.

The median return for the Russell 2000, post a decline of 15 percent or greater, was 98.8 percent. So we think while there could be a correction or a pullback in the market at any given time, the prognosis for the market going forward is actually one that is quite positive, in that the small-cap cycle still has room to run.

The second reversal, I think, is one that we’ve been talking about for a period of time that really started at the peak of the market in 2015, when the market peaked in June of 2015, and that’s this transition from growth to value.

Growth had dominated the small-cap space in terms of performance in six, of the previous seven years going into 2016. And last year, you saw a dramatic reversal of value’s outperformance.

Value outperformed growth within the small-cap space last year by a dramatic margin. And it’s a trend that we think can continue going forward.

The third reversal that we saw in the market last year has to do with the fact that cyclicals outperformed defensive stocks. For a period of time we had talked about how defensive, and really, safety in general, was overpriced in the market, especially within the small-cap space, where you saw healthcare do quite well; REITS and utilities as people were looking for dividend and equity bond-like proxies within the equity space. That reversed last year quite dramatically, and you saw cyclicals outperform.

The market was led last year really by financials, materials, and industrials. And within those sub-industries within those sectors, you saw many of the industrial areas do quite well, or cyclical areas do quite well.

Ironically, healthcare, which had been such a great performer in the market for many years, actually was the only negative sector within the Russell 2000 last year. So, that was a dramatic reversal we saw on the market.

I think inherent in the reversal that we saw within cyclicals and away from the defensive areas of the market is the fact that you are going to see that trend continue, for a variety of reasons.

You are seeing a steepening of the overall yield curve. You are seeing kind of the animal spirits come back a little bit to the overall market, especially in the post-election environment and the belief that you could see acceleration in terms of GDP growth; to be determined, but there is that ongoing belief that you might see acceleration in GDP growth going forward, which we think, along with potential tax cuts and the baton being passed really from monetary to fiscal policy, would be a clear benefit for many small-cap companies that derive the majority of the revenue in the United States.

Article By Francis Gannon – The Royce Funds