Small-Caps Bounce Back—And Then Some

Following their ‘ugh-ly’ showing in 2024’s second quarter, small-caps rebounded in the third quarter, posting a robust advance on both an absolute and relative basis. The Russell 2000 Index increased 9.3% for 3Q24, outpacing the large-cap Russell 1000 Index (+6.1%) and the mega-cap Russell Top 50 Index (+4.2%). Returns for the major Russell indexes showed had a circumflex or caret-shaped pattern in the third quarter, with the Russell Microcap Index up 8.3% and the Russell Midcap Index advancing 9.2%.

Small-Caps Rising
Russell Index Returns, 6/30/24-9/30/24

Past performance is no guarantee of future results.

These encouraging results belie somewhat the uneven and divergent pattern of performance in the quarter. The Russell 2000, for example, got all/most of its positive results in a stellar July, when it advanced 10.2%, before cooling off in August (-1.5%) and September (+0.7%). Large-caps, on the other hand, experienced a smoother ride, with low but positive returns in each month for both the Russell 1000 and Russell Top 50.

Returns for non-U.S. stock indexes lined up in a similar pattern. The MSCI ACWI ex-USA Small-Cap Index gained 8.9% for 3Q24 and 11.9% for the year-to-date period ended 9/30/24, while the MSCI ACWI ex-USA Large-Cap Index was up 7.7% in 3Q24 and 14.8% for the year-to-date period ended 9/30/24.

The Long Road Back to Market Leadership

Of course, there was no shortage of news in the quarter, with arguably the biggest, at least from an investment standpoint, coming in mid-September when the Fed (finally) enacted a 50 basis point interest rate cut, along with signals that a second reduction might happen before the end of the year. Inflation continued to moderate while unemployment remained low, and GDP was revised upward.

Even against this promising backdrop, we understand that small-caps face a long road back to the top, as large-caps still held a commanding lead through the first nine months of 2024. For the year-to-date period ended 9/30/24, the Russell 2000 gained 11.2% versus respective gains of 21.2% and 27.3% for the Russell 1000 and Russell Top 50. However, we think a confluence of factors can help small-caps sustain market leadership, which we detail below.

A Look Inside Small-Cap

Almost as welcome as small-cap’s outperformance was the strength of value in the third quarter. The Russell 2000 Value Index increased 10.2% in 3Q24 versus a gain of 8.4% for the Russell 2000 Growth Index. The strength of the small-cap value index came disproportionately from Financials (which accounts for almost 30% of the index), and within that sector from banks (which accounts for almost 20% of the index—more than any sector, never mind industry groups). All but one of the remaining 10 sectors made positive contributions in the third quarter, with Energy the only detractor.

Paralleling the year-to-date dynamic between small- and large-cap, the Russell 2000 Value remained behind the Russell 2000 Growth for the first nine months of 2024, up 9.2% versus 13.2%, though the spread was much narrower between the small-cap style indexes through the end of September. We suspect that the growing economy should continue to help value stocks in the coming months.

The Small-Cap Sector Story

Within the overall Russell 2000, the array of contributions was similar to what worked in the small-cap value index. Financials was the top contributor, though its share of 3Q24’s return was lower, followed by Health Care, Industrials, and Real Estate. Two of these are highly interest rate sensitive sectors, while many Health Care businesses likely saw the potential benefit of refinancing floating rate debt at more attractive rates. The only detractor was Energy. The top industries for 3Q24 were banks and biotechnology, followed at an appreciable distance by household durables from Consumer Discretionary.

A Strong Quarter for 10 of 11 Small-Cap Sectors
Russell 2000 Sector Detractors and Contributors for 3Q24

Past performance is no guarantee of future results.

On a year-to-date basis through 9/30/24, all 11 sectors were in the black, with the top four contributors clustered fairly close together: Industrials, Financials, Information Technology, and Health Care. The top industries were biotechnology, technology hardware, storage & peripherals from Information Technology, and banks.

Are Small-Cap’s Stars Aligning?

We think the still growing U.S. economy and a more historically typical interest rate environment can be a winning combination for small-cap leadership, notwithstanding the levelling off of July’s results for the Russell 2000 in August and September. Our constructive outlook is rooted in three data-driven observations. First, it is rare for the Russell 2000—or any other equity index—to enjoy a double-digit monthly return. For small-caps, it has happened only 22 times since the Russell 2000’s 12/31/78 inception. The average subsequent 3-, 6-, and 12-month returns for small-caps following a 10% or higher monthly performance were impressive—and well above the Russell 2000’s monthly rolling averages, as can be seen in the chart below.

Double-Digit Monthly Returns Led to Strong Subsequent Small-Cap Returns
The Russell 2000’s Average Monthly Returns After 10%-Plus Months versus Monthly Rolling Returns Since Inception (12/31/79)

Past performance is no guarantee of future results.

In light of the Fed’s recent rate reduction, we also examined what small-caps have done following previous rate cuts. Our study took us back to November of 1957 (Fed Funds rate data goes back to July if 1954, with the first cut in 1957). As we always do when looking farther back than the 12/31/78 inception date for the Russell 2000 and Russell 1000, we used the Center for Research in Security Prices 6-10 (“CRSP 6-10”) and CRSP 1-5 Indexes as our respective proxies for small- and large-cap stocks. The chart below shows that small-caps beat large-caps in the 3-, 6-, and 12-month periods following Fed rate reductions—and averaged double-digit returns in each period.

Small-Caps Performed Well Following Previous Fed Rate Cuts
CRSP 6-10 and 1-5 Performance After Initial Fed Rate Cuts

Past performance is no guarantee of future results.

The Russell 2000’s average annualized 3-year returns have been underwater for several months—which is unsurprising given that small-caps finished the 3Q24 still not having reached a new peak, their prior peak having come almost three years ago on 11/8/21. In fact, the Russell 2000 finished the third quarter down -4.7% since that peak while large-caps continued to make new highs into the end of September. The average annual total return for the 3-year period ended 9/30/24 was 1.8%. So, our third observation looks at what happens to small-cap performance following periods of low or negative performance, specifically, the aftermath of 3-year annualized returns of 3% or lower. As seen in the chart below, these periods of below average performance were followed by periods of higher-than-average returns.

99% of the Time, Positive 3-Year Returns Have Followed Low Return Markets
Subsequent Average Annualized 3-Year Performance for the Russell 2000 Following 3-Year Annualized Return Ranges of Less Than 3%, 12/31/81-9/30/24

Past performance is no guarantee of future results.

In addition, small-cap has an advantage over large-cap in terms of estimated earnings growth for the rest of 2024 and 2025. Looking at our preferred index valuation metric of enterprise value over earnings before interest & taxes shows that relative valuations for the Russell 2000 versus the Russell 1000 finished September near their lowest level in 25 years. Bolstering the absolute and relative attractiveness of small-caps is the state of the Russell 2000’s price-to-earnings ratio, which was below its 25-year weighted harmonic average at the end of 3Q24. In our view, this adds up to a favorable portrait, that we will delve into more in my interview with Chuck Royce later this week, where we offer more details about what makes us so confident in the long-term prospects for active management in small-cap.

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