What Could 3Q19’s Reversals Mean Going Forward?
article , video 11-13-2019

What Could 3Q19’s Reversals Mean Going Forward?

Senior Investment Strategist Steve Lipper makes his case for why 3Q19’s reversals suggest a long-term rebound.


Some recent research we’ve done in the small-cap area has uncovered several striking observations. We find three areas of relative valuation that are at or near 20-year lows. Let’s go through them one by one. First, small-caps versus large-caps. Small-caps sell at a greater discount than they have since 2001 versus large-caps. What’s particularly notable about that is over the last 20 years, small-caps have usually sold at a premium to large-caps.

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies) from 12/31/01 to 9/30/19


1 Earnings before interest and taxes
Source: FactSet

Next, value versus growth. Small-cap value sells at a discount to small-cap growth that we haven’t seen since the Internet bubble.

Russell 2000 Value and Growth Shifted Median Relative LTM EV/EBIT¹
Russell 2000 Value/Growth from 12/31/01 to 9/30/19

relative evebit

1 Last twelve months enterprise value/earnings before interest and taxes.
Source: FactSet

And finally, small-cap cyclicals sell at a greater discount than we have seen at any time over the last 20 years. But the point I particularly want to draw a contrast to is that small-cap cyclicals today sell at a greater discount to defensives than they did in the fall of 2008, when there was widespread concern that we were headed into a significant economic decline. So we can see to what degree small-caps versus large-caps, value versus growth, and cyclical versus defensive, are all out of favor.

Russell 2000 Relative Median EV/EBIT¹ (Ex Negative EBIT)
From 9/30/99 to 9/30/19

relative ev-ebit

1 Earnings before interest and taxes

What’s really striking to us is what happened about the middle of the quarter to all three of those relationships. Coming into the quarter and through August 27th, all of the prior leadership—large-cap, small-cap growth, and small-cap defensives—were leading. And then something remarkable happened. They all reversed.

Three Reversals Within 3Q19


Small-cap was lagging on the downside in the first half of that quarter and then came back to rally a little over 1% from the 27th through the end of the quarter. The rebounds in value and growth and defensive and cyclical were even more striking. Small-cap value lagged by about 2.5% coming into August 27th and then rebounded to over 6%. And the cyclicals, as there was greater concern about recession the first half of the quarter, cyclicals lagged defensives by about 3.8%, but then rebounded to over 5% from that 27th.

How do we distill all of this? What does it suggest to us? Well, it’s striking to us that all three relative valuations were at or near 20-year lows, and all three reversed beginning on the same day. It suggests to us that the probabilities are that that reversal is the beginning of a long-term rebound for small-caps over large, for small value over growth, and for small-cap cyclical over defensive.

More Small-Cap Perspectives


Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of October 8, 2019 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: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

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