Chuck Royce and Francis Gannon are optimistic for small-caps going forward despite negative market sentiment.
Small-caps had a decent quarter despite negative economic news and market sentiment. Why do you think that happened?
Are you surprised that large-cap and growth stocks both continued to do well in 2Q19?
CR: We also see several indicators that suggest small-caps may be poised to rebound versus large-caps. First, small-caps actually declined over the past 12 months, whereas large-caps advanced, and that’s a relatively rare divergence. It’s happened less than 7% of the time over the past 20 years—in 16 out of 229 periods. And in more than 90% of the following 12-month periods—13 of the 14 with subsequent periods—small-caps outpaced large-caps. As Frank noted, small-caps historically have tended to struggle relative to large-caps when yields are falling as well as in periods of slowing economic growth. If one or both of those factors reverse in the coming years, and history suggests they should, we would also expect small-caps to reassert leadership.
What Happened After 12-Month Periods When Large-Caps Rose and Small-Caps Fell?
Are you encouraged by the rebound for cyclical stocks in 2Q19?
What is your outlook for cyclicals if the global economy continues to slow down?
For some time, we’ve thought that most investors place too much importance on daily macro headlines in trying to understand or anticipate small-cap market movements. For example, we continue to distinguish between slower economic growth and a contraction. And from our perspective, that’s a critical distinction. We also think that investors tend not to appreciate what’s often called “the reaction function,” the response of businesses, central banks, and governments to slowdowns. We’re certainly not macro forecasters, but we think that in light of current low expectations, there’s a decent chance the global economy could surprise on the upside over the next year.
FG: We often seek to identity opportunities at the intersection of quality and value. We define companies at that intersection as those with average or better profitability and lower-than-average valuations. Today, three cyclical sectors—Consumer Discretionary, Industrials, and Materials—possess this attractive combination of attributes. So while there have been numerous reports of negative revisions in the press, the earnings prospects for the second half of the year look solid for many of our holdings, especially in these three sectors. In some cases, they appear even more promising given the relatively weaker third and fourth quarters of 2018 to which this year’s second-half quarters will be compared.
Is this consistent with what you’ve been hearing from management teams?
What is your outlook around volatility?
I don’t see that shifting. With so much economic uncertainty, as well as the tendency we’ve observed over the last few years for certain industries to undergo corrections while others thrive, volatility looks as though it will be a more consistent presence in the market, which is fine with us because we’re often active buyers in volatile markets. We want to take advantage of temporarily depressed prices.
Are you concerned that the inverted yield curve is signaling a recession?
CR: It’s also important to remember that recessions are rare. Since the end of World War II, a period of almost 75 years, there have been twelve in the U.S., and only three of them lasted more than a year. Over the past 40 years, many of them were preceded or accompanied by steep increases in the Fed Funds rate or, as was the case most recently, a financial crisis. Neither of those scenarios looks likely to us currently. So while it’s certainly possible that we could have a recession in the next year or so, the yield curve is the only strong signal we see right now.
What is your take on the Fed’s holding the line while also leaving the door open to cutting rates at a later date?
What’s your outlook from here?
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.
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.
Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
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 yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
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