-- Steve Lipper, Senior Investment Strategist
Looking ahead to 2020, we see three favorable factors in place for small-cap stocks: a slow economy, an accommodative Fed, and the calendar, all of which add up to positive prospects for this asset class.
That conviction reflects our recent research into what had happened historically when market, monetary, and seasonal conditions were similar to what we have in the U.S. today. This research uncovered some interesting historical patterns that offer a sizable measure of encouragement to small-cap investors now.
When economic, monetary, and market conditions have looked similar to today’s, small-caps have enjoyed subsequent returns nearly twice their historical average while avoiding losses the vast majority of the time. This three-ingredient cocktail is near-term weak economic growth, an accommodative Fed, and positive seasonality.
Most investors are aware that small-caps are more subject to cyclicality than their large-cap siblings and that small-caps typically do well when the economy is expanding. However, many investors may not be aware that the weaker the current economy, the stronger subsequent small-cap returns tend to be.
Our analysis began by taking an investment start date during months when the ISM Manufacturing Index was in the bottom 25% of its historical readings—that is, less than 49.3—since 1978. From those low points, the subsequent average 12-month return for the Russell 2000 Index was 21.4% compared with 12.8% for all 12-month periods since the small-cap index’s 1978 inception.
Most investors also know that an accommodative Fed has been good for equity returns regardless of cap size. If we add environments when the Fed Funds rate was lower than it was 12 months prior with those periods of low ISM Manufacturing Index readings, the subsequent small-cap results were even stronger, with an average subsequent 12-month return under these dual conditions of 24.3%.
Small-Cap Results in Two Scenarios vs. Long-Term Rolling Average
The percentage of periods in which investors avoided a loss in these environments was also striking—and are especially relevant for cautious investors concerned about preserving capital and avoiding losses. In periods with both low economic readings and an accommodative Fed, small-cap returns were positive in 82% of all one-year periods, 91% of two-year periods, and 99% of three-year periods.
Russell 2000 Monthly Rolling 1-Year Returns by Starting ISM Level (%)
From 12/31/78 through 9/30/19
Source: FactSet 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 changes. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The final component to this bright outlook for small-cap performance is seasonality. Across the globe, equities as a whole have enjoyed higher historical median returns from October through March than they have from April through September. Explanations vary as to the cause of this pattern, but regardless of the reasons, we think it’s important that investors know about it. For the Russell 2000, the historical median return for the six-month period from October through April was 8.9%, while it was only 4.4% for the April through September period.
The Historical Impact of Seasonality
With all three of these positive conditions currently present—low ISM Manufacturing Index readings, an accommodative Fed, and positive seasonality—we think the prospects for small-caps are attractive now.
Growth in the Slow Lane
Cautious Optimism Amid Change
Consumers Hold the Key
Looking Beyond the U.S.
Shifting the Global Balance
Uncertainty on the Horizon
How Infrastructure Is Evolving
Resilient Growth, Despite Risks
Small cap refers to stocks with a relatively small market capitalization. Market capitalization is the total dollar market value of all of a company's outstanding shares; it is calculated by multiplying a company's shares outstanding by the current market price of one share.
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.
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. Sub-indexes include the ISM Manufacturing and Non-Manufacturing Purchasing Managers' Index (PMI)
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 federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.
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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.
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