Don’t Trust Your Instincts

Small-cap stocks

Don’t Trust Your Instincts

History suggests that investors who shun small-caps after periods of low returns and high volatility could pay a price later on.


Unfortunately, most of us are saddled with poor instincts to be successful investors. This may seem surprising, but there are many activities for which our gray matter is ill suited without long years of training and discipline. Our brains evolved to be very good at trend extrapolation: the habit of expecting tendencies to remain in place. When humans were struggling to survive in our prehistoric years, this was a very useful instinct. A lush and vibrant area was expected to stay that way and be a better place to settle; a cold or arid place was not as suitable. Positive and negative experiences were both generally expected to continue.

However, a successful investor must have the opposite mindset. Positive and negative investment trends always persist for a while, but they also always eventually reverse. Notable investment gains may come from positioning one’s portfolio to benefit from such reversals. Our view is that we have arrived at exactly such a reversal period for small-cap stocks.

One of the most common tendencies for investors is to more heavily weight their portfolios in assets that have delivered attractive returns. However, investors should be mindful of a central tendency for any asset’s returns and to pay particular attention when that asset has delivered higher or lower returns than its long-term average. Perhaps most counterintuitively, caution is warranted when an asset has delivered significantly higher returns than its historical average. In contrast, when an asset has delivered returns at the low end of its historical range, it may be opportunity knocking.

Over the past three years through the end of April, small-caps stocks posted a modestly negative average annualized return of -0.8% And as modest as that negative three-year return is, it’s also very rare. It’s happened in only about 10% of all month-end periods (45 out of 449) since the inception of the Russell 2000 Index in 1978.

The typical wiring in a human mind might react adversely to this negative return, seeing it as unattractive. Yet history suggests exactly the opposite. Subsequent small-cap performance following three-year negative return periods has been unusually strong. As the chart shows, the subsequent average one-year return was 30.1% and the subsequent average three-year return was 18.9%, while the subsequent average five-year return was 16.1%. This performance translated to more than doubling one’s investment for the average five-year period. Instead of being avoided, areas that have delivered subpar returns may be an attractive place to look for future returns.

Average Returns Following Negative Russell 2000 3-Year Return Periods vs. Long-Term Averages

From 12/31/78 through 4/30/20

Bar Graph: Average Returns

Source: Factset, as of 3/31/20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

One can anticipate that readers might object that, while history is all well and good, we have never experienced anything like the current public health crisis and consequent economic shutdown, so how much credence can we give to these historical studies? While it’s true that we have never experienced anything like this situation before, this historical study includes similarly difficult and/or tumultuous periods including double-digit inflation in the early ‘80s, the ’87 Crash, the First Gulf War, the Internet Bubble, 9/11, and the Great Financial Crisis, all of which were also unprecedented before they happened. Historically, markets have demonstrated remarkable resilience when recovering from unprecedented experiences.

Let’s address one more counterintuitive observation about small-caps, which has to do with what might be called market storms. Investors’ risk aversion understandably rises during market storms. When a severe storm is raging, there’s a fear that it may last for an extended period. But these storms always ultimately pass. For markets, volatility (or the VIX) is a useful measure of the intensity of these storms. For April 2020, the daily VIX averaged 41.5%, a very high level that's in the highest 10% of all months since the inception of the VIX in 1989.

Does that suggest investors should reduce risk after periods of high volatility? History actually points in the opposite direction. If we look at returns that follow periods of high volatility, we find high returns for small-caps, as the table below shows. The subsequent average one-year return was 28.5% and the subsequent average annualized three-year return was 17.4%. Additionally, small-caps have a tendency to bounce back higher than large-caps after these highly volatile periods. In the periods just described, small-caps beat large-caps in 70% of the subsequent one-year periods and 81% of three-year periods.

Russell 2000 vs Russell 1000 Monthly Rolling VIX Regimes

Subsequent Average 1-Year Return Periods After VIX 1-Month Average was ≥ 28% from 12/31/89 through 3/31/20

Source: Factset, as of 3/31/20. VIX was ≥28% in 37/351 periods.The table above measures the average returns and spread of the monthly trailing three-year return periods in month where the monthly average three-year VIX level falls within the specified range. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

If investors listened to their instincts, they might avoid small-caps after a period of low returns and high volatility. History indicates that investors could pay a price for trusting those often faulty impulses and instead should take a hard look at small-caps now.


Definitions:

The 1987 Crash, also called Black Monday, occurred on October 19, 1987 and was a sudden, severe and largely unexpected systemic shock impaired the functioning of the global financial market system, roiling its stability through a stock market crash, along with crashes in the futures and options markets.

The September 11 attacks (also referred to as 9/11) were a series of four coordinated terrorist attacks by the Islamic terrorist group al-Qaeda against the United States on the morning of Tuesday, September 11, 2001.

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.

The Great Financial Crisis (GFC), also known as the Great Recession, the financial crisis of 2007–08, global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared

The tech bubble (also known as the dot-com bubble and the Internet bubble) was a stock market bubble caused by excessive speculation in Internet-related companies in the late 1990s.

The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (109) Jin Guan Tou Gu Xin Zi Di 016; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.