4Q19 Small-Cap Investment Review & Outlook—Royce
article 01-02-2020

4Q19 Small-Cap Investment Review And Outlook

4Q19 was a strong one for small-cap stocks, capping a healthy 2019, which may go down as the Year of the Pivot and unrealized fears. What might be next for 2020?


4Q19—The Smaller, the Better (with one exception)

The final quarter of 2019 was a strong one for the major U.S. and global equity indexes. Consistent with the market rotations that began in late August, results were generally better the farther down the capitalization range one traveled, as micro-caps led, followed by small-caps and then large caps. The Russell Microcap Index surged 13.4% in 4Q19 while the Russell 2000 increased 9.9% and the Russell 1000 advanced 9.0%.

The most notable outlier in 4Q19’s performance array were mega-caps, whose strong results gave the quarter a U-shaped return pattern. The Russell Top 50 Index rose 10.5% for 4Q19, outpacing its large- and mid-cap counterparts. Mega-caps have been outrunning the rest of the U.S. equity market since the middle of 2018 to the point that they look close to a bubble. The unwinding of this bubble—and the potential for subsequent investor rotation to small-caps—is part of our optimistic outlook for small-caps.

Market Rotations and Reversals Hold

We began to track the market’s reversals from August 27th, which inverted previous market leadership patterns. From that late summer date through the end of 2019, these rotations held; small-caps outpaced large-caps, cyclicals outperformed defensives, small-cap value beat small-cap growth, and micro-caps led domestic equity performance for this four-month period. For the quarter, however, the Russell 2000 Growth Index was ahead of the Russell 2000 Value Index, up 11.4% versus 8.5%.

Interestingly, even after a strong absolute quarter, relative valuations for small-cap versus large-cap, small-cap cyclicals versus small-cap defensives, and small-cap value versus small-cap growth remain near the 20-year lows they were at on 8/27/19. These historically low valuations offer additional support for our expectation that the performance reversals for these pairings can be sustained.

Cyclicals Consistent, Defensives Diverge

Ten of the 11 sectors in the Russell 2000 finished 4Q19 in the black, with only Utilities detracting from results. This poor performance was part of a larger trend of underwhelming results for bond proxies as Real Estate, Communication Services, and Consumer Staples also underperformed the index as a whole, making these four the worst small-cap sector performers in 4Q19.

Health Care, on the other hand, made the biggest contribution by far to 4Q19 results, lifted by a strong showing for biotech, whose advance was aided by a bevy of acquisitions (keyed in part by advances in various gene therapies), along with index-beating performances from pharmaceuticals and health care providers & services.

Cyclicals showed far more consistency as a group. Following Health Care, the highest sector returns in 4Q19 came from Information Technology, Materials, and Consumer Discretionary.

2019: Broad-Based Success For Small-Cap Stocks

Small-cap results for 2019 were impressive as the Russell 2000 increased 25.5%, placing it in the index’s top 27% of calendar-year showings since its 1978 inception. However, it’s important to recall this result was also a rebound from the depths of 2018’s fourth-quarter meltdown. The robust first and fourth quarters bookended two quieter periods, which is a fairly typical small-cap return pattern.

The breadth of the advance was notable, with 70% of Russell 2000 stocks posting positive returns, 61% advancing at least 10%, and 49% posting a yearly gain of 20% or more. Sector breadth was even stronger as 10 of 11 Russell 2000 sectors were positive for the year (Energy was the sole detractor). Information Technology led, followed by notable positive results for Industrials, Health Care, and Real Estate.

2019: The Year of the Pivot

We see the market’s success in 2019 as being rooted mostly in the assuaging of two fears that were not realized: a more hawkish Fed and a U.S. recession. The Fed raised rates last December, indicating at that time that 2019 would likely see multiple rate hikes. This news accelerated the market’s downward trajectory, prompting the Fed to initially move to a more neutral stance, stating that it was unlikely to raise rates in 2019.

This “Fed Pause” evolved into a “Fed Pivot,” as the central bank initiated three rate cuts in 2019, which reversed all of the central bank’s increases in 2018. Equally important from our perspective was the injection of more liquidity into the market. While not technically QE, this increase in liquidity was clearly supportive for financial assets. The view of an accommodative Fed was further confirmed by their announcement of a $500 billion money market capital injection in December.

The second positive development was the absence of a recession, a concern that has periodically stressed the market over the last couple of years (e.g., in 2011, 2015, and 2019). While the pace of the U.S. economy has slowed, growth remains positive. The U.S. consumer has been the workhorse of the economy, and the remarkably strong U.S. housing and labor markets have helped to compensate for the slackening pace of manufacturing growth.

Each of these positive developments helped to allay investors’ worries throughout the year, contributing to strong calendar-year returns.

Our Constructive Outlook

So what comes next? We suspect that if one made a list of all the obstacles, both real and imagined, that faced investors in 2019, the strength of equity performance would come as a great, albeit pleasant, surprise: Tariffs and trade wars, an inverted yield curve, sluggish global growth, uncertain prospects for China, political controversies, the specter of greater regulation for tech giants, and the possibility of a recession.

To be sure, it’s remarkable that investors tuned out much or all of this headline noise, focusing instead on companies’ results and how likely they were to continue to execute. While small-cap earnings growth was lower in many cases, most companies’ earnings remained positive. In fact, nearly the same number of Russell 2000 companies posted operating earnings so far in 2019 as in 2018 (1,467 in 2018 versus 1,406 in 2019), despite decelerating economic growth and in defiance of pessimistic predictions.

Against this backdrop, we feel reasonably confident entering 2020. We have previously cited four favorable factors in the current market environment—low inflation, modest valuations, moderate growth, and increased access to capital. These factors continue to suggest that the overall direction of small-cap returns is likely to be higher. With the caveat that we lack 20/20 vision, we see a global economy that’s showing signs of renewed life, an ISM Manufacturing Index that’s been incrementally rising, and, most important, valuations that range from reasonable to attractive among the many small-cap cyclical areas that we typically like best.

Two additional historical factors are worth noting. First, over the past 30 years, 76% of all monthly rolling 1-year returns for small-caps have been positive, with an average return of 11.5%. Investors betting on a small-cap decline, in other words, are betting against the odds. Second, to get a sense of what might happen in 2020, we looked at the 11 previous times since the Russell 2000’s inception in which there was a calendar-year decline, as in 2018, and what happened in the second, subsequent year. In nine of those 11 years (2000 and 2002 were the exceptions), the Russell 2000 advanced by an average of 14.5%.

And so it’s not uncommon for small-caps to advance by double digits for two consecutive years. In fact, history offers several periods when one robust year was followed by a very healthy second one for the Russell 2000, including 1988-9, 1991-2, 1995-6, 2003-4, 2009-10, 2012-13, and 2016-17. Bearing in mind the favorable conditions we’ve outlined above, we suspect that the current small-cap rally can continue, with the potential to add 2019-20 to this list.



Important Disclosure Information

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partners, and, of course, there can be no assurances with respect to future small-cap market performance.

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. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

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.

The ISM Manufacturing Index (ISM) monitors employment, production, inventories, new orders and supplier deliveries.

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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.



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