Anatomy of a Recovery
article 05-16-2023

Anatomy of a Recovery

Co-CIO Francis Gannon discusses why, with so much attention on a recession, we are looking three to five years down the road toward an eventual recovery.

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Officially speaking, the U.S. economy is not in a recession, but hardly a day goes by without some mention of the word “recession.” Most economists are predicting one, corporate management teams are preparing for one, and even the minutes from the Federal Reserve’s March Federal Open Market Committee meeting include a projection that the U.S. economy will enter one later this year. In fact, fear of an impending recession has been hashed out for more than 18 months now. The reasons are myriad, be it the inversion of the yield curve, the unprecedented speed at which the Federal Reserve has been raising rates, or ongoing geopolitical uncertainty. What you do not hear much about in these uncertain days, however, is what shape a recovery would take and how investors should position themselves.

“Given the constant short-term focus of the markets today, it can be difficult to look out three to five years to an environment where the economy and markets are likely to be growing again. We believe the small-cap environment is replete with opportunities, with what we think are attractive valuations in many cases.”
— Francis Gannon

From our perspective, the likelihood of a recession seems to have been growing of late 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. At the end of the April, the average stock in the Russell 2000 Index was down -35.3% from its 52-week high. While the catalyst for a recovery is, like so much else, not clear now, one will eventually emerge, and we think investors should start positioning themselves accordingly. Related to this is the fact that small cap’s historical performance patterns show that below-average longer-term return periods have been followed by above-average longer-term return periods.

When five-year annualized returns for small caps are 5% or less, as they are as of this writing, history has shown that subsequent annualized three-year returns have been positive 100% of the time—that is, in all 84 three-year annualized periods— and averaged 17.7%, which was well above its monthly rolling average three-year return of 9.8% since the Russell 2000’s 12/31/78 inception.

The small-cap index also enjoyed positive annualized five-year returns 100% of the time—that is, in all 81 five-year periods—following five-year periods when annualized returns were 5% or lower. In fact, the Russell 2000 averaged an impressive five-year return of 14.9%, well above its monthly rolling five-year return since inception of 9.6%. In this context, it’s worth noting that the average annualized five-year return for the Russell 2000 was 3.2% as of 5/9/23 and 4.7% for the five years ended 3/31/23.

Subsequent Average Annualized 3- and 5-Year Performance for the Russell 2000 Following 5-Year Annualized Return Ranges of Less Than 5%
From 12/31/83 through 4/30/23

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

Past performance is no guarantee of future results.

Given the constant short-term focus of the markets today, it can be difficult to look out three to five years to an environment where the economy and markets are likely to be growing again. We believe the small-cap environment is replete with opportunities, with what we think are attractive valuations in many cases. So, while the near-term view remains cloudy, and recession remains a possibility, its length and severity are unknowable. In addition, the small-cap market appears to have largely discounted this outcome. We also know that any recession, like any bear market, is ultimately finite and will in all probability be succeeded by a recovery. While the catalyst for a recovery is equally unknowable, we continue to patiently use this volatile market to position our portfolios for the recovery that will undoubtedly come.

Stayed 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 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 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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