Small-Caps Shift In A Wild Quarter by Francis Gannon, The Royce Funds
In a volatile quarter full of downs and ups, equity returns wound up close to where we started in 2016. Underlying these unremarkable results was the real story—the leadership shift to small-cap value.
Small-Caps Shift: Another Wild Ride — Volatile Market & Muted Returns
Rarely before has a quarter seen such high volatility for small-cap stocks (Russell 2000 daily volatility was higher than 87% of all quarters since inception) with such a muted return (-1.5%).
The quarter split into near mirror images, with a decline of 15.9% through the YTD low on 2/11 and a subsequent rebound of 17.1% through the end of March.
Our Outlook: This sort of tumult is typical of a market undergoing a change in leadership.
small-caps shift
Is the Worst Behind Us?
From the small-cap market peak on 6/23/15 through 2/11/16, the Russell 2000 Index lost 25.7%.
This loss is close to the median return of -27.7% for all declines of 15% or greater (from prior index peaks) since the inception of the Russell 2000 on 12/31/78. However, all five periods with declines of 30% or more were accompanied either by a recession (1990, 2002), a dramatic financial market event (1987, 1998), or both (2008-2009).
Our Outlook: While it’s difficult to rule out a “black swan” financial event, in the absence of that or a recession, which we think is unlikely, we believe the worst of the small-cap decline is behind us.
Small-Cap Leadership Shift — Value Over Growth
In the volatile first quarter, the Russell 2000 Value Index took the lead, advancing 1.7%, considerably better than the Russell 2000 Growth Index, which fell 4.7%.
The period of outperformance for small-cap value actually extends back to last June’s small-cap peak, as the Russell 2000 Value outperformed the Russell 2000 Growth Index, -9.6% vs.-16.2% from 6/23/15 through 3/31/16.
This style reversal is important as the prior extended period of growth’s outperformance helped to create a meaningful headwind for most active managers.
Our Outlook: We expect that small-cap value’s leadership period has a long way to go.
Odd Couple: Utilities Lead, Health Care Lags
There was a surprising mix in quarterly small-cap sector results. The best performers within the Russell 2000 were Utilities, Telecommunication Services, and Materials, though solid results also came from more cyclical, economically sensitive areas such as Consumer Discretionary and Industrials.
It’s unusual for that collection of sectors to do well in the same quarter. On the flip side, another uncommon pairing— Health Care and Energy— showed the greatest losses.
Our Outlook: We think that Materials and Industrials can make progress versus low expectations, while Health Care and certain once fast-growing areas of IT may continue to struggle.
Mid-Cap Noses Ahead
In another surprise, mid-cap stocks led for the quarter, with the Russell Midcap Index up 2.2% versus an advance of 1.2% for the Russell 1000 and respective declines of 1.5% and 5.4% for the Russell 2000 and Russell Microcap Indexes. The steepest losses generally came from the smallest companies.
Due to recent underperformance, the Russell 2000 now sells at only a 3% P/E premium to the Russell 1000 Index, compared to a 24% premium at year-end 2013.
Our Outlook: We anticipate that small-cap stocks will at least keep pace and may likely lead large-caps in the next upswing.
Earnings Mattered
The quarter also saw better performance for small-cap companies with earnings. Profitable companies in the Russell 2000 advanced 1.6%, while non-earners dropped 17.6%.
This disparity was significant as investors reversed course and (finally) seemed to recognize both the value of earnings and how low valuations had fallen outside the few industries that were successful in 2015.
Our Outlook: As capital markets are not nearly as open and generous as they were previously, we believe the market will continue to reward profitability while showing less patience with non-earning companies.
