FINANCIAL PROFESSIONALS ONLY
U.S. Small-Cap Market Overview
March 31, 2024
Table of Contents
51Q24 Sector and Industry Review
6Small-Cap P/Es Are Still Below Average
7Small-Cap Looks Cheap, Particularly versus Mid- and Large-Cap Growth
9Historically Small-Cap Cycles Have Averaged More Than a Decade
10Small-Cap’s Weight in the Russell 3000 Is at a 20-Year Low
11Large-Cap Cycles Peak at Market Tops Crowded with Mega Caps
12Relative Valuations for Small-Caps vs. Large-Caps Are Near Their Lowest in 25 Years
13Wide Breadth of Undervaluation Across the Small-Cap Asset Class
15Small-Cap Estimated Earnings Growth is Expected to be Higher in 2024 than Large-Caps
16When the Equal-Weighted Russell 1000 Outperformed, Small-Cap Generally Led
1799% of the Time, Positive 3-Year Returns Have Followed Low Return Markets
18Small-Caps Generally Have Strong Three-Year Returns After Periods of High Volatility
19Historical Small-Cap Performance Post Final Fed Rate Hikes
20Small-Caps Have Beaten Inflation in Every Decade Since the 1930’s
Market Overview
After stumbling in the first month of the year, the Russell 2000 Index rose a more than respectable 5.2% in 2024’s opening quarter, trailing the Russell 1000 Index, which gained 10.3%. The large-cap index continued to be dominated by mega-cap stocks, as evidenced by the 11.9% advance for the Russell Top 50 Index in 1Q24. Once more, returns skewed higher the further up the capitalization scale one went, with the Russell Microcap Index up 4.7% for the quarter.
In our view, however, these quarterly results for the U.S. equity indexes do not tell the whole story. From the most recent small-cap low on 10/27/23, the Russell 2000 advanced 30.7% and the Russell 1000 was up 28.9%. Moreover, from that low through 2023’s high on 12/27/23, the small-cap index rose 26.6% versus 17.2% for the Russell 1000. The Russell Microcap Index was especially strong, rising 30.8% over this 60-day span, while the Russell Top 50 was up “only” 14.8%. It seems to us that the first quarter of 2024 was a consolidation period—a common occurrence after particularly sharp short-term rallies—when investors took gains and/or flew back to the—perceived in our estimation—safety of mega-cap stocks. From 12/28/23 through 3/31/24, the Russell 2000 had a 3.2% gain while the Russell Microcap was up 2.5%, the Russell 1000 rose 10.0%, and the Russell Top 50 was up 11.6%.
1Q24 Small-Cap Overview
The Russell 2000 Growth Index outperformed the Russell 2000 Value Index in 1Q24, gaining 7.6% versus 2.9% respectively. The quarter saw high quality outperform, low leverage outperform high leverage, and the highest profitability companies outperform the lowest. Interestingly, non-dividend payers outperformed dividend payers.
1Q24 Sector and Industry Review
Boosted by technology hardware & equipment, the Information Technology sector was the clear winner in 1Q24, up 12.8%, followed by the Energy, Industrials, and Consumer Discretionary sectors. Communication Services and Utilities were the worst performers for the quarter losing 4.9% and 3.6%, respectively. All told, seven of the 11 sectors made positive contributions for the quarter.
Small-Cap P/Es Are Still Below Average
The average price to earnings ratio for the Russell 2000 (ex non-earners) on 3/31/24 was 16.3x —still below its long-term average of 17.9x. While returns have just started to rebound, multiples have remained compressed, creating a considerable number of buying opportunities.
Small-Cap Looks Cheap, Particularly versus Mid- and Large-Cap Growth
Four observations leap out when comparing various segments of the U.S. equity market: 1) Small-Cap Value and Small-Cap Core are the cheapest segments of U.S. equities, 2) these segments are the only ones slightly above their 25-year average valuation, 3) while all three value segments (Small-Cap, Mid-Cap, and Large-Cap) have nearly identical 25-year average valuations, their current valuations are vastly different, and 4) Mid-Cap Growth and overall Large-Cap valuations still have a long way to fall to reach their 25-year average valuations.
Historical Perspective
Small-cap has still not established a new all-time high since its most recent peak on 11/8/21. So, it’s been almost two-and-a-half years, which makes it the second-longest period since the index’s 1979 inception that the Russell 2000 has gone without reaching or exceeding a peak—and the last one occurred during the 2008-09 Financial Crisis. As of 3/31/24, the Russell 2000 was down -9.9% from its November 2021 peak. Meanwhile, the large-cap indexes continued to reach new highs into March 2024.
Small-caps continue to be near their lowest relative valuation versus large-caps in more than 20 years, and small-cap’s weighting in the Russell 3000 is also near a 20-year low. Finally, we think that one important consequence of interest rates normalizing is that access to capital now has real costs—which should benefit conservatively capitalized, fiscally prudent small-cap companies and the asset managers who hold them. The mounting costs of indebtedness mean that advantages should accrue to companies with low debt, the ability to generate free cash flow, and the proven ability to allocate capital prudently and effectively.
Historically Small-Cap Cycles Have Averaged More Than a Decade
Secular changes in economic trends, interest rates, and monetary and fiscal policies are altering the long-term investment landscape. The winners under the past decade’s zero interest rate, low inflation, and low nominal growth regime will no longer lead. The unfolding macro environment points to the small-cap asset class being able to sustain, not just tactically outperform, large-cap.
Small-Cap’s Weight in the Russell 3000 Is at a 20-Year Low
Small-caps’ underperformance versus large caps has reached an extreme point. Other than the COVID-related market trough in March 2020, small-caps are at their lowest weighting in the Russell 3000 in more than 20 years, another indicator suggesting that a small-cap rebound may be coming.
Large-Cap Cycles Peak at Market Tops Crowded with Mega Caps
Relative Valuations for Small-Caps vs. Large-Caps Are Near Their Lowest in 25 Years
Following small-cap’s underperformance of large-cap, the Russell 2000 remains extremely undervalued compared to its relative valuation range over the past 25 years.
Wide Breadth of Undervaluation Across the Small-Cap Asset Class
The disparity in sector valuations in small-cap versus large-cap is notable and further reflects the idea that the market is defensive and that a potential recession has been mostly priced in within small-cap.
Small-Cap Market Outlook
We remain highly confident about the long-term prospects for our chosen asset class. While always cautious about reading too much into a short-term performance period such as a single quarter, we believe that a leadership shift is upon us. From the most recent small-cap low on 10/27/23, the Russell 2000 advanced 30.7% and the Russell 1000 was up 28.9%. Moreover, from that low through 2023’s high on 12/27/23, the small-cap index rose 26.6% versus 17.2% for the Russell 1000.
Against the backdrop of moderating inflation, normalized interest rates, and a still growing U.S. economy, it looks to us that small-cap’s lengthy stretch in the relative performance wilderness has run its course. Our reasoning is rooted in the notion that as the economy continues to stabilize, valuations are likely to rise for those businesses that have largely sat out the mega-cap performance regime. Such a move is likely to benefit small-caps more than larger companies. And large-cap cycles have historically peaked at market tops crowded with mega-caps. As bottom-up small-cap stock pickers, however, the most significant factor for us is that majority of the management teams we’ve been speaking to remain cautiously optimistic over the long run. With no recession having materialized after nearly three years after its imminent arrival being predicted, we see the increasing likelihood of a soft landing for the resilient U.S. economy—which will begin to see more tangible benefits of reshoring, the CHIPS Act, and numerous infrastructure projects in 2024.
Amid the difficulties of volatile markets and periods of economic uncertainty, we think it’s crucial to remind investors of the opportunity to build their small-cap allocation at attractively low prices. History shows the rewards that have accrued to investors who had the necessary patience and discipline to stay invested during periods of sluggish or negative performance. We continue to see the currently unsettled period as an opportune time to invest in select small-caps for the long run.
Small-Cap Estimated Earnings Growth is Expected to be Higher in 2024 than Large-Caps
After a difficult year in 2023, small-cap earnings are poised to re-accelerate through the rest of 2024. Our contention that as the U.S. economy experiences ever more tangible benefits accrued from reshoring, the CHIPS Act, and several infrastructure projects, advantages will flow to many small-cap companies.
When the Equal-Weighted Russell 1000 Outperformed, Small-Cap Generally Led
Our research shows that when large-cap returns broaden, small-caps outperform. When the equal-weighted Russell 1000 beat the capitalization-weighted Russell 1000, the Russell 2000 outperformed the large-cap index over the majority of rolling 1-, 3-, and 5-year periods going back to 1984.
99% of the Time, Positive 3-Year Returns Have Followed Low Return Markets
The three-year average annual total return for the Russell 2000 as of 3/31/24 was -0.1%. Small-cap’s historical return pattern shows that below-average return periods have been followed by those with above-average returns, with a much lower-than-average frequency of negative return periods. Specifically, the Russell 2000 had positive annualized three-year returns 99% of the time—that is, in 66 out of 67 periods—averaging an impressive 16.7% following three-year periods of less than 3% annualized returns.
Small-Caps Generally Have Strong Three-Year Returns After Periods of High Volatility
Historical Small-Cap Performance Post Final Fed Rate Hikes
Small-Caps Have Beaten Inflation in Every Decade Since the 1930’s
Key Takeaways for 1Q24
Market Overview
After stumbling in the first month of the year, the Russell 2000 Index rose a more than respectable 5.2% in 2024’s opening quarter, trailing the Russell 1000 Index, which gained 10.3%. The large-cap index continued to be dominated by mega-cap stocks, as evidenced by the 11.9% advance for the Russell Top 50 Index in 1Q24. Once more, returns skewed higher the further up the capitalization scale one went, with the Russell Microcap Index up 4.7% for the quarter.
In our view, however, these quarterly results for the U.S. equity indexes do not tell the whole story. From the most recent small-cap low on 10/27/23, the Russell 2000 advanced 30.7% and the Russell 1000 was up 28.9%. Moreover, from that low through 2023’s high on 12/27/23, the small-cap index rose 26.6% versus 17.2% for the Russell 1000. The Russell Microcap Index was especially strong, rising 30.8% over this 60-day span, while the Russell Top 50 was up “only” 14.8%. It seems to us that the first quarter of 2024 was a consolidation period—a common occurrence after particularly sharp short-term rallies—when investors took gains and/or flew back to the—perceived in our estimation—safety of mega-cap stocks. From 12/28/23 through 3/31/24, the Russell 2000 had a 3.2% gain while the Russell Microcap was up 2.5%, the Russell 1000 rose 10.0%, and the Russell Top 50 was up 11.6%.
Historical Perspective
Small-cap has still not established a new all-time high since its most recent peak on 11/8/21. So, it’s been almost two-and-a-half years, which makes it the second-longest period since the index’s 1979 inception that the Russell 2000 has gone without reaching or exceeding a peak—and the last one occurred during the 2008-09 Financial Crisis. As of 3/31/24, the Russell 2000 was down -9.9% from its November 2021 peak. Meanwhile, the large-cap indexes continued to reach new highs into March 2024.
Small-caps continue to be near their lowest relative valuation versus large-caps in more than 20 years, and small-cap’s weighting in the Russell 3000 is also near a 20-year low. Finally, we think that one important consequence of interest rates normalizing is that access to capital now has real costs—which should benefit conservatively capitalized, fiscally prudent small-cap companies and the asset managers who hold them. The mounting costs of indebtedness mean that advantages should accrue to companies with low debt, the ability to generate free cash flow, and the proven ability to allocate capital prudently and effectively.
Key Takeaways for 1Q24 (continued)
Small-Cap Market Outlook
We remain highly confident about the long-term prospects for our chosen asset class. While always cautious about reading too much into a short-term performance period such as a single quarter, we believe that a leadership shift is upon us. From the most recent small-cap low on 10/27/23, the Russell 2000 advanced 30.7% and the Russell 1000 was up 28.9%. Moreover, from that low through 2023’s high on 12/27/23, the small-cap index rose 26.6% versus 17.2% for the Russell 1000.
Against the backdrop of moderating inflation, normalized interest rates, and a still growing U.S. economy, it looks to us that small-cap’s lengthy stretch in the relative performance wilderness has run its course. Our reasoning is rooted in the notion that as the economy continues to stabilize, valuations are likely to rise for those businesses that have largely sat out the mega-cap performance regime. Such a move is likely to benefit small-caps more than larger companies. And large-cap cycles have historically peaked at market tops crowded with mega-caps. As bottom-up small-cap stock pickers, however, the most significant factor for us is that majority of the management teams we’ve been speaking to remain cautiously optimistic over the long run. With no recession having materialized after nearly three years after its imminent arrival being predicted, we see the increasing likelihood of a soft landing for the resilient U.S. economy—which will begin to see more tangible benefits of reshoring, the CHIPS Act, and numerous infrastructure projects in 2024.
Amid the difficulties of volatile markets and periods of economic uncertainty, we think it’s crucial to remind investors of the opportunity to build their small-cap allocation at attractively low prices. History shows the rewards that have accrued to investors who had the necessary patience and discipline to stay invested during periods of sluggish or negative performance. We continue to see the currently unsettled period as an opportune time to invest in select small-caps for the long run.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. All performance information is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements. 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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 1000 index is an unmanaged, capitalization-weighted 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 Top 50 Mega Cap Index is an unmanaged, capitalization-weighted index of domestic mega-cap stocks that measures the performance of the 50 largest publicly traded U.S. companies in the Russell 3000 index. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes approximately 800 of the smallest securities in the Russell 1000 Index. The Russell Midcap Value and Growth Indexes consist of the respective value and growth stocks within the Russell Midcap as determined by Russell Investments. The Russell 1000 index is an unmanaged, capitalization-weighted 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 1000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 1000 as determined by Russell Investments. The Bloomberg Barclays US Aggregate Bond Index is an unmanaged, capitalization-weighted index of investment grade, US dollar-denominated, fixed-rate taxable bonds. 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 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 (Center for Research in Security Prices) CRSP (Center for Research in Security Pricing) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Royce & Associates, LP, the investment advisor of The Royce Fund and Royce Capital Fund, is a limited partnership organized under the laws of Delaware. Royce & Associates, LP primarily conducts its business under the name Royce Investment Partners.
Sector and industry 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.
Notes, Performance and Risk Disclosure