2018’s Small-Cap Decline: Recession or Risk Reset?—Royce
article , video 02-21-2019

Interpreting 2018’s Decline: Recession Or Risk Reset?

Francis Gannon provides his perspective on the 2018 decline and details the areas he thinks the market is overlooking.


What’s your perspective on the 2018 decline?

I’m in the camp that this is a normal decline in the overall market. This has been a de-risking of the market, which happens periodically. In fact, in the 10 years we’ve seen since the Great Recession of 2007, 2008 this is the third decline in small-caps, third bear market within the small-cap market, and all have been driven by what I would call a growth scare. 2011 it was driven by a fear of a double-dip recession in the United States. 2015 and ’16 it was driven by Asia’s issues at the moment, China specifically, and then once again another China issue at the end of last year.

We lived in a world in 2018 where people were looking for the next recession, almost wanting the next recession, and the correction in the market almost became a self-fulfilling prophecy in many respects in the latter part of the year. But to me it was a simple de-risking, and you can say that purely because you saw many classic signs within the small-cap market in that de-risking moment. Value outperformed growth. Defensives did better than cyclicals—kind of your normal pattern that we’ve seen historically.

A Familiar Pattern in 4Q18 Decline


What’s your outlook for 2019?

I think 2019 is actually going to be a decent year for the small-cap space. I think if you go look back historically over the history of the Russell 2000, following severe declines—last year was our 12th negative year for the Russell 2000— in 10 of the 11 previous declines you’ve actually seen nice returns for the Russell over the subsequent year with an average of about 21%. One time that did not take place was in ’07 into ’08 as we were heading into the Financial Crisis.

Is a Decline in the Russell 2000 a Buy Signal?
Russell 2000 Declines and Subsequent Calendar Year Performance as of 12/31/18


While I don’t see a 21% return for the Russell next year, although it is possible—who knows what’s going to happen—I do think you’ll see more muted returns. I do think that the market’s going to be okay, and this is a great opportunity for small- cap investors in the small-cap space.

Which areas do you think the market is overlooking?

I think key to the market in 2019 is going to be selectivity. Active management is a big portion of that, and I think part of that is going to be driven by the fact that earnings should be better for select companies. While the overall market and the overall index itself might see earnings come down a little bit, I do think you’re going to see certain strength of earnings in certain areas of the market, industrials being one of them.

Cyclical Market Disconnect


I think there are sectors out there, more economically sensitive or cyclical areas of the market that should advance and do quite nicely from an earnings perspective that the market really hasn’t focused on yet. You’re hearing that many companies are actually very optimistic about the economy—I should say cautiously optimistic about their specific outlook—I think you’re going to get more earnings opportunities.

More Small-Cap Perspectives


Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of January 9, 2018 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

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.

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

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