Uncertainty Rules the Current Market—Royce
article 12-12-2018

Uncertainty Rules the Current Market

Co-CIO Francis Gannon looks at the current downturn and explains why we’re confident in our small-cap holdings during these highly uncertain days.


The recent downturn for stocks, along with increased market volatility, has shown no signs of slowing down as of mid-December.

Much of the current period’s bearish feel has been attributed to two combined concerns: the relatively old age of the equity cycle and the perception that U.S. economic growth has peaked. Each of these anxieties continues to be exacerbated by trade war and tariff talk, among other factors.

Some of the reactions, on the part of both investors and market commentators, seems a bit extreme to us. This year’s decline, for example, has so far been well within the historical range of small-cap pullbacks—yet many are describing it as if we’re already in the midst of historically memorable market plunge.

Since 1997, however, the Russell 2000 Index has had 22 intra-year declines, with the median pullback of 14.0%, which is close to what small-caps have experienced so far in 2018—the Russell 2000 reached its most recent low on December 10, falling 16.8% from its all-time high on August 31. (And a fall from an all-time high is always apt to inspire a raft of fatalistic commentary.)

2018 Decline Has So Far Been Normal
Penn Top Stocks

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.

As the chart shows, only seven of the 22 downturns were losses of 25% or more. Five of these were post-bubble periods related to recessions or significant U.S. economic slowdowns—2000, 2001, 2002, 2008, and 2009. The other two—in 1998 and 2011—came close on the heels of international financial crises.

We don’t see the current likelihood of these kinds of seismic events in the near term. It’s true that U.S. economic data is mixed, with ISM numbers remaining strong, for example, while housing and job gains have slowed. Other worrisome signs can be seen in the ongoing weakness in China and throughout much of Europe.

But mixed data is far from evidence of a soon-to-contract economy. On balance, then, this looks to us more like the gradual deceleration of a fast-growing economy rather than a slam of the brakes. We don’t see signs of an imminent recession or appreciable weakening of economic growth.

“We’re confident that the small-cap companies we hold, in particular those with low debt, solid cash flows, and effective managements, are likely to weather a more volatile, slower-growth, and lower-return environment more successfully while we acknowledge that these days are even more uncertain than usual.” - Francis Gannon

Of course, we are not economists—our expertise is in stock selection. The bulk of our measured confidence is rooted more in what we’re hearing from the management teams we talk to on a regular basis than on macroeconomic data.

Most of the news we hear continues to be positive, leavened by concerns over tariffs and inflation. Equally important, the earnings growth we’ve seen and analyzed indicates that many of the profitable small-cap businesses in cyclical industries that we hold look as well prepared as they can be for an uncertain 2019.

Our thought is that U.S. economic data is more likely to go from, say, very good to pretty good than to contracting. Even more important, based on this take we are pleased with what we’re holding during this admittedly challenging time.

We believe the market is going through a long overdue de-risking period, one that is creating what we see as attractive long-term buying opportunities. So while it’s certainly possible that the market could continue falling into bear territory—by which we mean a decline of at least 20%—we think the economy is fundamentally sound, at least for now.

To be sure, corrections of any sort are never pleasant, and we see our long-term orientation as particularly important during tumultuous markets.

From this perspective, we’re confident that the small-cap companies we hold, in particular those with low debt, solid cash flows, and effective managements, are likely to weather a more volatile, slower-growth, and lower-return environment more successfully while we acknowledge that these days are even more uncertain than usual.

Stay tuned…

Important Disclosure Information

Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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