A Rally, A Few Downgrades, and a Potential Pause
article 08-15-2023

A Rally, A Few Downgrades, and a Potential Pause

Co-CIO Francis Gannon discusses why recent short-term outperformance may be signaling a leadership shift in favor of small cap.


What a difference a few months can make! “Soft landing” has become the dominant market narrative, gone (for the moment) are the once ubiquitous predictions of looming recession risk, and now healthy disinflation talk is all the rage. Not all is rosy, however. While bond yields have backed up, the overall curve remains firmly inverted. Fitch downgraded U.S. government debt, and Moody’s downgraded the credit ratings of 10 U.S. banks, while putting six others on watch. Inflation, while clearly improving, remains stubbornly above the Fed’s target. Even so, and as we have predicted, the equity market has rallied and started to broaden out. In fact, the Russell 2000 Index has outperformed the large-cap Russell 1000 and S&P 500 Indexes, as well as the Nasdaq, over the past two months, though it still trails all three year-to-date. Small cap’s recent upturn in performance has coincided with an improvement in earnings, as reported second quarter earnings have been solid, and 2024 negative revisions have so far been fewer and/or lower than expected.

“At the end of June, the collective weight of small caps in the broad Russell 3000 Index was lower than it was throughout the Internet bubble—after which the Russell 2000 embarked on a multi-year period of outperformance.”
—Francis Gannon

Of course, the question remains, can small caps continue to outperform given their recent short-term outperformance? We continue to believe that small caps are at the beginning of what will be a prolonged outperformance cycle as they look inexpensive and have underperformed the broader market for the better part of a decade. Small cap valuations still look highly favorable on both an absolute basis and relative to large cap, where they remain close to a 20-year low based on our preferred valuation metric of enterprise value over earnings before interest & taxes. Even with the recent strong move, the average stock in the Russell 2000 was down -25.0% off its 52-week high at the end of July, which gives a sense of the opportunity set that still exists within small cap. At the end of June, the collective weight of small caps in the broad Russell 3000 Index was lower than it was throughout the Internet bubble—after which the Russell 2000 embarked on a multi-year period of outperformance.

Small Cap’s Weight in the Russell 3000 Is at a 30-Year Low
Russell 2000 Weight in the Russell 3000 from 6/30/93 through 6/30/23 (%)

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)

Finally, as we approach the pre-Covid peak in the market, which occurred in late August 2018, the Russell 2000’s average annualized 5-year return was a paltry 4.0% at the end of July. Perhaps we have stressed the historic outperformance of the Russell 2000 following these low return periods too much of late. Yet, in an uncertain world where the battle between economic growth, inflation, disinflation, a constantly looming recession, and an aggressive Fed has produced extremely narrow market leadership, history and experience are even more important for understanding the potential for future returns. History shows us that these low return periods for small caps have led to positive annualized five-year returns 100% of the time—in all 81 five-year periods—averaging an impressive 14.9%, which was well above the Russell 2000’s monthly rolling five-year return since inception of 10.4%. Experience tells us that now is the time for small caps and, importantly, active management.

So, while it would not surprise us to see the market take a pause and digest recent gains (as has so far been the case in August), we firmly believe that a new small-cap cycle is at hand even as economic risks abound and clouds remain on the horizon.

Stay tuned…

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.

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 1000 Index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. The Russell 3000 Index is a capitalization-weighted stock market index that seeks to be a benchmark of the entire U.S. stock market. It measures the performance of the 3,000 largest publicly held companies incorporated in America as measured by total market capitalization and represents approximately 97% of the American public equity market. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor’s based on market size, liquidity, and industry grouping, among other factors, and includes reinvested dividends. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Returns for the market indexes used in this report were based on information supplied to Royce by Russell Investments. Royce has not independently verified the above described information.

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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