Small Cap Rotation, Reopening, and Reversion—Royce
article 12-01-2020

Small Cap Rotation, Reopening, and Reversion

CO-CIO Francis Gannon explains why he thinks November’s rotation into small caps looks likely to last.

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November was a powerful month for equity markets across the globe as the prospects for economic normalization spurred by a coronavirus vaccine took center stage. The month also saw a marked rotation toward small-cap stocks, accompanied by a corresponding move to value and cyclical names. In fact, U.S. small caps just completed their best month in the history of the Russell 2000 Index, gaining 18.4% in November, while the Russell 2000 Value Index advanced 19.3%. While one month does not constitute a trend, the shift toward both small caps and value would appear to reflect the emerging transition to a broad-based economic recovery premised on a vaccine and subsequent widespread reopening. The question for investors currently is whether or not this rotation is sustainable.

History suggests that it will be. The record of previous economic recoveries shows that small caps and cyclicals have been the greatest beneficiaries coming out of recessions—and we see no reason why this would change in the current economic environment. To be sure, we have already seen evidence of this in select cyclical industries, such as road and rail, air freight, and building products, demonstrating positive momentum over the last few months. And this observation becomes even more compelling if the dollar continues to weaken and thus creates more export opportunities.

1-Year Returns from the Deepest Small-Cap Market Troughs of the Last 20 Years

cyclical and defensive 1yr returns after trough

Past performance is no guarantee of future results.

These significant market troughs were accompanied by recessions. As we would expect, cyclicals led in the subsequent recoveries. Perhaps most important for investors—though the news was largely lost among the election coverage and vaccine announcements—was the surprisingly robust state of third-quarter earnings for many small-cap companies. Earnings will be paramount to equity market performance going forward, especially in small caps, as strong earnings rebounds offset declines in valuation. In addition, earnings comparisons should be quite forgiving through most of next year. However, we also continue to believe that selectivity will be key because economic activity is likely to remain uneven as growth continues to rev up.

As a firm, we continue to focus our attention on the individual opportunities at hand. Even as the market has been recovering, our Deep Value Team has been investing in companies that look attractively inexpensive and capable of growth in an improving economy. Most recently, the portfolio management team has added names in cyclical end market sectors, including consumer stocks that would benefit from a vaccine and consequent return to normal. The team also saw an opportunity with an auto supplier that looked well positioned to take advantage of growing demand for passenger and commercial vehicles, as well as longer-term trends in electric transport. Our Premier Quality Strategy’s focus on sustainable, durable business models has led that management team to opportunities in iconic consumer brands, fallen real estate firms, and IT research specialists that will benefit as the economy recovers in 2021.

There is a synchronized global recovery gradually unfolding, supported by the likely imminence of vaccines and the lagging impact of massive monetary and fiscal stimulus. All of this should continue to reward global small caps—and cyclicals in particular. Both are overdue for reversions back to market leadership. We would expect November’s rotation to continue, though we also anticipate volatility and consolidation. Reversion to the mean can be an extremely powerful force—as we just saw in November—but it also rarely occurs in a straight line.

Stay tuned…

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Important Disclosure Information

Mr. Gannon’s thoughts and opinions concerning the stock market are solely their 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.

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.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

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. All indexes referenced are unmanaged and capitalization weighted. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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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