A Small Gain Masks a Quarter of Extremes for Small-Cap Stocks
The Russell 2000 Index gained 2.7% in 1Q23, a small gain that masked some noteworthy extremes. Small caps first advanced 13.7% year-to-date through 2/2/23 before continued Fed hawkishness and a resurgence of recession fears combined to drive stock prices lower. These losses were then exacerbated by the failures of Silicon Valley (SIVBQ, Financial) and Signature Banks (SBNY, Financial), along with related worries over the fragile condition of First Republic Bank (FRC, Financial) and Credit Suisse (CS, Financial). Investors were concerned, for understandable reasons, that the banking industry might be facing the kind of contagion that threatened the stability of the global economy and financial markets in 2008. (Their sizable weightings in regional banks pressured quarterly returns for both the Russell 2000 and Russell 2000 Value Indexes.)
An Up and Down Quarter for Stocks
Russell 2000 Daily Values 12/31/22-3/31/23
Of course, these wide-ranging moves are becoming something of a norm for the Russell 2000: in five of the last six quarters, the index experienced an increase of at least 10% and a decline of at least 10% intra-quarter, while for the last six consecutive quarters small caps have seen either an advance or a loss of at least 10%.
With Treasury yields behaving with the sort of high volatility we’re used to seeing in speculative equities, it was perhaps not surprising that investors flocked back to the—perceived in our view—safety of mega-cap stocks, such as Meta Platforms (META, Financial), Apple (AAPL, Financial), Microsoft (MSFT, Financial), and Alphabet (GOOG, Financial), all of which rallied through the end of March. The upshot was that small caps were behind their larger and more growth-oriented peers for the quarter, with the Russell 1000 Index up 7.5%, the Russell Top 50 Mega Cap Index up 12.9%, and the Nasdaq Composite up 17.0%.
The dynamic outside the U.S. was similar insofar as large caps outpaced small caps, but the spread was considerably narrower. The MSCI ACWI ex USA Small Cap Index gained 4.7% in 1Q23 while the MSCI ACWI ex USA Large Cap Index advanced 7.0%. The absence of mega-cap tech stocks in the latter index and smaller regional banking stocks in the former likely had an impact on respective returns for each index.
A Pause for Small-Cap Value
After a mostly steady run of outperforming its growth sibling over the last eight quarters, the Russell 2000 Value Index took a back seat in 1Q23, down -0.7% versus a gain of 6.1% for the Russell 2000 Growth Index. This led to the small-cap value index losing, at least for now, certain longer-term advantages. While the Russell 2000 Value beat the Russell 2000 Growth for the three- and five-year periods ended 3/31/23, it trailed small-cap growth for the one- and 10-year periods ended 3/31/23.
However, we would remind, and caution, investors that the pivot in Fed policy from the epoch of zero (or near zero) interest rates and easy money to one of rate hikes and quantitative tightening, both against the backdrop of persistent inflation, means a radically altered investment landscape. The stocks that performed best under the previous decade’s regime of zero interest rates, low inflation, and low nominal growth are unlikely to lead going forward, regardless of what direction the U.S. economy ultimately takes. Conversely, those areas of the equity market that lagged during this long period are likely, in our view, to capture long-term leadership.
The State of Small Cap
Small-cap stocks remained in an ongoing bear market at the end of 1Q23, declining -24.7% from their most recent peak on 11/8/21 through 3/31/23. And many stocks suffered even sharper losses over the last year. The average stock in the Russell 2000 was down -35.2% from their respective 52-week highs through the end of March 2023.
Moreover, the average annualized five-year return for the Russell 2000 was 4.7% as of 3/31/23, substantially lower than its 10.4% monthly rolling five-year average annualized return since inception (12/31/78). And while its 17.5% average annualized three-year return looked far better, we think in this case that looks may be deceiving: the three-year period ended 3/31/23 began just as the market was shaking off its Covid-driven bottom on 3/18/20. By way of contrast, the annualized return for the Russell 2000 from 2/20/20—just before the onset of the pandemic’s destructive effect on the market—was a paltry 2.8% through 3/31/23.
We believe this is especially relevant now because low-return periods for small caps have usually been followed by above-average performance periods. In fact, the Russell 2000 enjoyed positive annualized five-year returns 100% of the time—that is, in every one of its 81 five-year periods—and averaged an impressive 14.9% following five-year periods with annualized returns of 5% or less.
100% of the Time, Positive 5-Year Returns Have Followed Low Return Market
Subsequent Average Annualized 5-Year Performance for the Russell 2000 Following 5-Year Annualized Return Ranges of Less Than 5% from 12/31/83 through 3/31/23
Repeated Reasons to Be Cheerful
At the end of 2022, we offered an optimistic long-term perspective, specifically for value, cyclical, and high quality (which we primarily define as companies with high returns on invested capital). Our overall view has not shifted. The market remains in something of a holding pattern, with low or negative returns the understandable corollary to an uncommonly uncertain period. Inflation has fallen but is still sticky, and the Fed is committed to bringing it lower. The likelihood of a recession seems to have grown and has certainly been well telegraphed, with certain observers having promised one for at least the last year. We think these warnings of widespread demand destruction have given well-managed companies ample lead time to prepare while also allowing for the lion’s share of the negative economic news to have been priced in to select small caps.
We therefore risk repeating a point we made in January of this year: Since the end of World War 2, most down years for small caps have been followed by positive performance. Prior to 2022, there were 24 years in which small caps had a negative calendar year return (using the Center for Research in Securities Prices (“CRSP”) 6-10 as our longer-term small-cap proxy). In 19 of the subsequent years, which equates to 79% of the time, small caps enjoyed a positive return the following year. Perhaps even more notable was that the average return for those positive years following a negative one was 25.9%, a substantially better result than the 10% average return for calendar years that followed a positive small-cap return.
So, while the near-term view remains as cloudy as any we can recall, and recession is a possibility, its length and severity are unknowable. What we do know is that any recession, like any bear market, is ultimately finite and will in all probability be succeeded by a recovery. History also shows that small caps will likely start moving up before many of us know for sure that the economy has begun growing again.
Finally, bear markets always challenge investors to stay invested as prices are falling. Yet another critical lesson from history is that the market’s subsequent recovery is enjoyed most by those with the patience and discipline to remain in the market. Periods like the last 12-18 months have sorely tested every investor’s forbearance. But more than 50 years of portfolio management have taught us that these are often the most rewarding times to be invested in select small-cap stocks for the long run.
Missing the Rally’s Earliest Stage Has Been Costly
Average Returns for the Russell 2000 During the First 12 Months of a Recovery Depending on Entry Point from 12/31/78 through 3/31/23
Past performance is no guarantee of future results.
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. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
None of The Royce Funds held shares of Silicon Valley Bank, Signature Bank, Credit Suisse Group, UBS Group, and/or First Republic Bank as of 3/31/23.
