Where small caps could go from here

3Q19 review and outlook

Where small caps could go from here

Returns for most U.S. small-cap equities were mixed in 3Q19, but unexpected and welcome reversals were the real story.

3Q19—Two Markets in One Quarter

Results for the major U.S. indexes were flat to negative and aligned along the size spectrum in 3Q19. The large-cap Russell 1000 Index was up 1.4%, the Russell 2000 Index finished the third quarter down 2.4%, and the Russell Microcap Index fell 5.5%.

Beneath this seemingly calm surface, however, there was a lot of action. In essence, everything that had been leading the market for the last two-plus years staggered through the market's September recovery while previous laggards took on leadership.

Reversals and Rotations

The rotation began with the market's recovery on August 27th following down months in July and August. This rebound included a number of simultaneous reversals that inverted the market leadership patterns we've seen during recent upward moves for equities.

The upshot was that from 8/27/19-9/30/19 small-caps outpaced large-caps, small-cap value beat small-cap growth, and cyclicals outperformed defensives, in each case by solid margins. All of these areas were lagging for the quarter, year-to-date or one-year periods prior to the market's recovery.

A tale of two markets

Intra-quarter small cap returns

Source: Bloomberg, as of 9/30/19. 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.


At the sector level, the most sizable contributions came from Industrials and Financials, followed by Consumer Discretionary and Real Estate. So while most of the sectors in the Russell 2000 were positive (Health Care detracted slightly) during this short rebound, cyclicals markedly outperformed defensives.

And while leadership rotation is common, what makes 3Q19 unusual was that the rotation happened more or less simultaneously on 8/27/19. Additionally, the rotations remained solidly in place amid considerable geopolitical developments and domestic political issues.

It was even more interesting to us that small-cap value handily beat its growth counterpart on an upward move—which has been an infrequent occurrence of late, in particular because the pattern of growth winning on the upside has mostly been the market's norm for much of the last few years.

In fact, 3Q19 returns were consistent with valuations as the cheapest 20% of small-caps (as measured by free cash flow to enterprise value) posted a modest gain while the most expensive quintile within the Russell 2000 declined by double digits.

More important, the relative valuations for small-cap versus large-cap, small-cap value versus small-cap growth, and small-cap cyclicals versus small-cap defensives were at or near 20-year lows on 8/27/19. So while no one knows if these reversals will be lasting, it seems reasonable to suggest that reversions to the mean were overdue in all three cases.

What Bellwether Industries May Be Signaling

In trying to get a sense of the sustainability of these reversals, we looked at the relative strength of industries within the index so far this year. What we saw were notable performances from three economically sensitive industries that are also economic bellwethers—construction materials, semiconductors & semiconductor equipment, and building products.

From our perspective, it appears that investors are responding to the absence of bad news about the U.S. economy. They appear to have recognized that there is an important difference between slower growth—which we have—and a recession, for which the prospect still looks remote.

And with rates and inflation equally low, a slow- to moderate growth environment is a healthy one for equities.

Bulls vs. Bears

Let's consider the following pros and cons for ongoing positive equity performance—contrasting the more bullish perspective with a bearish point of view.

The latter look at the slowing pace of U.S. growth, the even more sluggish state of growth outside the U.S., and the ongoing negative impact of tariffs and trade wars. They worry that the declining U.S. ISM Manufacturing Index (a common proxy for economic conditions) is flashing a recession warning. They point to the fact that there is now more than $17 trillion in negative yielding debt worldwide, with 30% of all investment grade securities bearing sub-zero yields.

This is all genuinely worrisome. But before ceding the argument to market fatalists, we would counter with the following: the U.S. consumer continues to spend and enjoy confidence—in large part thanks to a robust labor market and wage growth.

Moreover, credit markets are healthy—as are financial conditions overall, which are providing increasing amounts of liquidity to the capital markets. And in our area of expertise, we continue to see reasonable to attractive valuations for many small-cap holdings—which also look much less expensive than most of the their large-cap counterparts. In addition, the corporate management teams that we speak with remain cautiously constructive—few if any are worrying about recession.

Where Do Small-Caps Go From Here?

Over the last four quarters, small-caps have gone straight down (4Q18) and straight up (1Q19), before treading water over the most recent two.

The market, in other words, is still searching for direction. Stocks do not move sideways indefinitely. At some point, they either break down or break out.

In this murky context, we think there are two key questions: Can small-cap earnings growth improve from here? If yes, then we see a breakout; if not, a breakdown. What might drive small-cap earnings growth? Three areas are currently weak—and may soon be bottoming: year over year small-cap EPS growth, the ISM Manufacturing Index, and Western European and Chinese economies.

To be sure, when thinking about the prospects for small-cap stocks, it is also important to remember that we are still in the historically anomalous situation of positive trailing one-year returns for the Russell 1000 (3.9%) with negative results for the Russell 2000 over the same period (-8.9%). Over the past 20 years, this divergence has occurred only 8% of the monthly trailing one-year periods.

In our view, investors might want to keep in mind not only how rare this particular performance disparity has been, but also that the historical frequency for a favorable small-cap reversal has been very high.

Rare Return Divergence

Trailing 1-Year Periods from 9/30/99 through 9/30/19

Source: Bloomberg, as of 9/30/19. 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.

The current economy remains a fascinating mix of paradoxical data, which creates foggy conditions when trying to look forward. When taken together, however, we see attractive valuations and enough fundamental progress to suggest the probability of a shift to small-cap leadership.


Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. An index EPS is an aggregation of the EPS of its component companies.

Free cash flow (FCF) to enterprise value (EV) is a ratio comparing FCF to EV. Free cash flow (FCF) is measure of financial performance calculated as operating cash flow minus capital expenditures. It represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value. Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.

Growth refers to stocks of companies whose earnings are expected to grow at an above-average rate relative to the market. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects.

The Institute for Supply Management's (ISM) Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction

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.

The Russell Microcap Index measures the performance of the microcap segment of the U.S. equity market. Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smallest eligible securities by market cap.

Value refers to an investment approach that aims to select stocks that trade for less than their intrinsic values.


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