2Q22 Small-Cap Recap—Royce
article 07-01-2022

2Q22 Small-Cap Recap

Nowhere to run and nowhere to hide in a bearish 2Q22.  

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Small-Cap's Worst-Ever First Half

The small-cap Russell 2000 Index fell 23.4% for the year-to-date period ended 6/30/22—which was the worst first-half performance in its more than 40-year history by a significant amount. While the historic depth of the decline was surprising, a negative result for small-cap stocks was not. A highly inhospitable climate consisting of restrictive Fed policies, increasing fears of recession, and persistent inflation combined to create the conditions for lower returns for most small-cap stocks.

Small-Cap's Dubious Achievement
Negative Calendar-Year First-Half Returns for the Russell 2000 Since Inception (12/31/78)

2022: -23.4%. 2020: -13%. 1982: -10.6%. 1984: -9.5%. 2008: -9.4%. 1994: -6.5%. 2002: -4.7%. 2010: -1.9%. 2005: -1.3%.

Past performance is no guarantee of future results.

Unsurprisingly, then, the second quarter of 2022 offered no safe havens for investors as these same factors, along with higher energy prices, conspired to drive prices lower—regardless of asset class, style, or geography. The small-cap Russell 2000 Index lost 17.2% for 2Q22, slightly lagging the large-cap Russell 1000 Index, which fell 16.7% for the same period. For historical context, 2Q22 ranked eleventh worst out of the 59 down quarters for the Russell 2000 since its inception (12/31/78).

The most notable performance spreads were not rooted in capitalization but in style, as growth stocks suffered more than their value siblings across asset classes. With interest rates rising sharply, these relative results were consistent with our view that growth stocks face considerable duration exposure, arguably more than investors appreciate. Within small-cap, the Russell 2000 Value Index was down 15.3%, outperforming the Russell 2000 Growth Index—which fell 19.3%—and recording small-cap value’s seventh consecutive quarter of outperformance.

In the Shadow of the Small-Cap Bear

While the major U.S. equity indexes sustained comparable losses for the quarter, 2Q22 extended a longer bearish pattern for small-cap stocks: a loss of 31.9% for the Russell 2000 from its last peak on 11/8/21 through the small-cap low on 6/16/22. As is typically the case during small-cap down markets, the degree to which the index fell understates the depth to which the average small-cap stock declined—a loss of 48% for the average stock in the Russell 2000 from their respective 52-week highs through the mid-June low. We think it’s important to note that the current depth of the small-cap market’s swoon is comparable to the median drawdown for the 12 declines of 20% or more since the Russell 2000’s inception. History thus suggests that the bulk of the small-cap decline is likely behind us.

Russell 2000’s Median Decline Suggests the Worst is Over
Median Decline of 20% or More for the Russell 2000 versus Most Recent Peak-to-Low Return (11/8/21-6/16/22)

Current drawdown: -31.9%. Median drawdown: -32.3%.

Past performance is no guarantee of future results.

It is striking to us how the current small-cap bear market has coincided with a period that boasts solid company fundamentals and growing profits. Small-cap profits (as measured by the trailing 12-month EBIT for the Russell 2000) grew by 53.5% over the last 12 months—a period in which the small-cap index fell 25.2% This divergence has led to a significant reduction in small-cap valuations. Using our preferred metric of EV/EBIT (enterprise value over earnings before interest & taxes), the Russell 2000 now has an average valuation of 14.1x, down from its 18.2x valuation a year ago, and below its 25-year average of 15.6x.

Additionally, small-cap value—which boasts most of the profitable companies within the asset class—has held up well throughout this challenging market (as we would expect). From November 2021’s high through the mid-June low, the Russell 2000 Value was down 22.9% while the Russell 2000 Growth lost nearly twice that, falling 40.4%. If interest rates continue rising, headwinds for growth stocks are likely to persist, while an eventual economic rebound should highly favor small-cap value stocks—as has been the case throughout history.

The Knowable versus the Unknowable

The questions we have been getting most during this highly volatile time are those for which no one has firm answers: Will there be a recession? How deep will it be? When will the Fed pause? Have we seen the bottom in small-cap prices? Indeed, these impactful uncertainties go a long way toward explaining why volatility has been so prevalent, based on both the higher historical average for the VIX, commonly known as the “fear gauge,” and the high percentage of days that the Russell 2000 moved up or down 1% or more during 2Q22.

High Anxiety Grips Small-Cap Investors
Percentage of Trading Days for the Russell 2000 with Moves of 1% or More for 2Q22 versus 30-Year Average

2022: 63%. Past 30 yers: 35%.

Past performance is no guarantee of future results.

Answers about the prospects for a recession and equally unanswerable questions concerning inflation and Fed policies are understandably at the forefront of investors’ minds. Yet, based on our decades of investment experience, a market low is impossible to predict. And more important, trying to answer these questions may be counterproductive. Engaging too deeply in our current uncertainties exposes one to the risk of becoming so mired in the unknown that paralysis can result. Instead, we think investors would be better served by following the investment maxim, “Be fearful when others are greedy, and greedy when others are fearful.”

The Case for Small-Cap

History suggests that challenging times have traditionally been good ones to enter the market—often by dollar-cost-averaging, as we believe there is no ideal date on which to invest. Looking to history for additional encouragement, we have data from the Center for Research in Security Prices at the University of Chicago (CRSP), which dates to 1945 and shows that small-cap stocks have posted positive annualized three-year returns 88% of the time on a rolling monthly basis, with an average return in the low double digits. To this degree, history offers clarity amid the uncertainty.

Equally, if not more important, we have found that the most opportune times to invest are when fear is high and trailing returns are low. As noted, the VIX is currently flashing a fear signal, ending June in the top 20% of its highest average monthly readings since its inception. Subsequent returns from these levels have been attractive—for investors with the fortitude to act.

Moreover, the annualized three-year return for the Russell 2000 at the end of June was 4.2% compared to its three-year monthly rolling average since inception of 10.9%. Subsequent annualized three-year returns for small-cap from comparable trailing low-return entry points have been positive 97% of the time since the Russell 2000’s inception, averaging 11.9%.

97% 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 0-5%
12/31/78-6/30/22

97%: 30/31 periods. Average subsequent 3-year return: 11.9%. Average 3-year monthly rolling return: 10.9%.

Past performance is no guarantee of future results.

Coming off a record negative first half during what appears to be a late stage of the bear market, the current period looks like a pretty good entry point for long-term small-cap returns going forward.

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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. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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. The performance data and trends outlined in this article 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. 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.)

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.

The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days and is quoted as an annualized standard deviation.

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 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 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. 

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