The Year of the Pivot

Small Cap Outlook

The Year of the Pivot

After a year of unrealized investor fears ended with impressive gains, what’s next for small-cap stocks?


4Q19—The Smaller, the Better (with one exception)

The final quarter of 2019 was a strong one for the major U.S. and global equity indexes. Consistent with the market rotations that began in late August, results were generally better the farther down the capitalization range one traveled, as micro-caps led, followed by small-caps and then large caps. The Russell Microcap Index surged 13.4% in 4Q19 while the Russell 2000 increased 9.9% and the Russell 1000 advanced 9.0%.

 

Source: Bloomberg, as of 12/31/2019. 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 most notable outlier in 4Q19’s performance array were mega-caps, whose strong results gave the quarter a U-shaped return pattern. The Russell Top 50 Index rose 10.5% for 4Q19, outpacing its large- and mid-cap counterparts. Mega-caps have been outrunning the rest of the U.S. equity market since the middle of 2018 to the point that they look close to a bubble. The unwinding of this bubble—and the potential for subsequent investor rotation to small-caps—is part of our optimistic outlook for small-caps.

Market Rotations and Reversals Hold

We began to track the market’s reversals from August 27th, which inverted previous market leadership patterns. From that late summer date through the end of 2019, these rotations held; small-caps outpaced large-caps, cyclicals outperformed defensives, small-cap value beat small-cap growth, and micro-caps led domestic equity performance for this four-month period. For the quarter, however, the Russell 2000 Growth Index was ahead of the Russell 2000 Value Index, up 11.4% versus 8.5%.

 

Source: Bloomberg, as of 12/31/2019. 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.

Interestingly, even after a strong absolute quarter, relative valuations for small-cap versus large-cap, small-cap cyclicals versus small-cap defensives, and small-cap value versus small-cap growth remain near the 20-year lows they were at on 8/27/19. These historically low valuations offer additional support for our expectation that the performance reversals for these pairings can be sustained.

Cyclicals Consistent, Defensives Diverge

Ten of the 11 sectors in the Russell 2000 finished 4Q19 in the black, with only Utilities detracting from results. This poor performance was part of a larger trend of underwhelming results for bond proxies as Real Estate, Communication Services, and Consumer Staples also underperformed the index as a whole, making these four the worst small-cap sector performers in 4Q19.

 

Source: Bloomberg, as of 12/31/2019. 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.

Health Care, on the other hand, made the biggest contribution by far to 4Q19 results, lifted by a strong showing for biotech, whose advance was aided by a bevy of acquisitions (keyed in part by advances in various gene therapies), along with index-beating performances from pharmaceuticals and health care providers & services.

Cyclicals showed far more consistency as a group. Following Health Care, the highest sector returns in 4Q19 came from Information Technology, Materials, and Consumer Discretionary.

2019: Broad-Based Success For Small-Cap Stocks

Small-cap results for 2019 were impressive as the Russell 2000 increased 25.5%, placing it in the index’s top 27% of calendar-year showings since its 1978 inception. However, it’s important to recall this result was also a rebound from the depths of 2018’s fourth-quarter meltdown. The robust first and fourth quarters bookended two quieter periods, which is a fairly typical small-cap return pattern.

 

Source: Bloomberg, as of 12/31/2019. 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 breadth of the advance was notable, with 70% of Russell 2000 stocks posting positive returns, 61% advancing at least 10%, and 49% posting a yearly gain of 20% or more. Sector breadth was even stronger as 10 of 11 Russell 2000 sectors were positive for the year (Energy was the sole detractor). Information Technology led, followed by notable positive results for Industrials, Health Care, and Real Estate.

2019: The Year of the Pivot

We see the market’s success in 2019 as being rooted mostly in the assuaging of two fears that were not realized: a more hawkish Federal Reserve (Fed) and a U.S. recession. The Fed raised rates last December, indicating at that time that 2019 would likely see multiple rate hikes. This news accelerated the market’s downward trajectory, prompting the Fed to initially move to a more neutral stance, stating that it was unlikely to raise rates in 2019.

This “Fed Pause” evolved into a “Fed Pivot,” as the central bank initiated three rate cuts in 2019, which reversed all of the central bank’s increases in 2018. Equally important from our perspective was the injection of more liquidity into the market. While not technically QE, this increase in liquidity was clearly supportive for financial assets. The view of an accommodative Fed was further confirmed by their announcement of a $500 billion money market capital injection in December.

The second positive development was the absence of a recession, a concern that has periodically stressed the market over the last couple of years (e.g., in 2011, 2015, and 2019). While the pace of the U.S. economy has slowed, growth remains positive. The U.S. consumer has been the workhorse of the economy, and the remarkably strong U.S. housing and labor markets have helped to compensate for the slackening pace of manufacturing growth.

Each of these positive developments helped to allay investors’ worries throughout the year, contributing to strong calendar-year returns.

Our Constructive Outlook

So what comes next? We suspect that if one made a list of all the obstacles, both real and imagined, that faced investors in 2019, the strength of equity performance would come as a great, albeit pleasant, surprise: Tariffs and trade wars, an inverted yield curve, sluggish global growth, uncertain prospects for China, political controversies, the specter of greater regulation for tech giants, and the possibility of a recession.

 

 

To be sure, it’s remarkable that investors tuned out much or all of this headline noise, focusing instead on companies’ results and how likely they were to continue to execute. While small-cap earnings growth was lower in many cases, most companies’ earnings remained positive. In fact, nearly the same number of Russell 2000 companies posted operating earnings so far in 2019 as in 2018 (1,467 in 2018 versus 1,406 in 2019), despite decelerating economic growth and in defiance of pessimistic predictions.

Against this backdrop, we feel reasonably confident entering 2020. We have previously cited four favorable factors in the current market environment—low inflation, modest valuations, moderate growth, and increased access to capital. These factors continue to suggest that the overall direction of small-cap returns is likely to be higher. With the caveat that we lack 20/20 vision, we see a global economy that’s showing signs of renewed life, an ISM Manufacturing Index that’s been incrementally rising, and, most important, valuations that range from reasonable to attractive among the many small-cap cyclical areas that we typically like best.

 

 

Two additional historical factors are worth noting. First, over the past 30 years, 76% of all monthly rolling 1-year returns for small-caps have been positive, with an average return of 11.5%. Investors betting on a small-cap decline, in other words, are betting against the odds. Second, to get a sense of what might happen in 2020, we looked at the 11 previous times since the Russell 2000’s inception in which there was a calendar-year decline, as in 2018, and what happened in the second, subsequent year. In nine of those 11 years (2000 and 2002 were the exceptions), the Russell 2000 advanced by an average of 14.5%.

And so it’s not uncommon for small-caps to advance by double digits for two consecutive years. In fact, history offers several periods when one robust year was followed by a very healthy second one for the Russell 2000, including 1988-9, 1991-2, 1995-6, 2003-4, 2009-10, 2012-13, and 2016-17. Bearing in mind the favorable conditions we’ve outlined above, we suspect that the current small-cap rally can continue, with the potential to add 2019-20 to this list.


Definitions:

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 2000 Growth Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their growth orientation.

The Russell 2000 Value Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their value orientation

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.

The Russell Top 50 Index measures the performance of the 50 largest companies in the Russell 3000 Index.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

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.

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

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.

Outperformance does not imply positive results.

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.