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?
Chuck Royce (CR): From my view, the resilience of small-cap stocks was both appropriate and encouraging given what we see as the solid state of small-cap fundamentals and the historically average level of many valuations. It’s interesting to me that the market’s mood over the previous two quarters—4Q18 and 1Q19—can best be described as extreme or overreactive, so the second quarter’s lower returns seemed pretty reasonable to us following a very strong first quarter when the Russell 2000 Index rose 14.6%. It’s not uncommon for there to be a pause after that kind of dramatic upward move as the market digests the prior advance. Additionally, the second quarter’s largest drawdown of 9.1% was very much in line with what small-caps have done historically. The median intra-year decline for the Russell 2000 over the past 25 years has been 14%.
Are you surprised that large-cap and growth stocks both continued to do well in 2Q19?
Francis Gannon (FG): I’d say we were more disappointed than surprised. Small-cap value stocks have now underperformed growth for the trailing quarter and year–to-date, as well as for the one-, three-, five-, and 10-year periods ended 6/30/19. Growth has enjoyed such a pronounced advantage for so long that we’ve now reached the point where the validity of value investing is being questioned, which to our ears sounds a little odd, to say the least. But it’s also not entirely surprising. I think for both large-caps and growth stocks, much of what’s been driving overall outperformance, over the last year or so in particular, has been lower rates. Historically, a low interest rate environment has been more favorable to large-caps and growth stocks. We’ve certainly seen that play out over the last couple of years.
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?
16 out of 229 Trailing 1-Year Periods from 6/30/99 to 6/30/19
Are you encouraged by the rebound for cyclical stocks in 2Q19?
CR: We were, in particular because cyclicals outperformed defensives in June. Low rates have often made it easy for the share prices of many defensive stocks to stay aloft. Along with slower economic growth, these factors have made it harder for most value stocks and a fair number of cyclicals to gain much sustainable traction among investors. So we were very pleased to see cyclicals—Industrials and Financials, most notably—perform so well. The cyclical tilt across our own strategies is rooted in research which indicates that these businesses are fundamentally sound and well-managed entities, so it was gratifying to see many companies that we like do well when the markets rebounded in June.
What is your outlook for cyclicals if the global economy continues to slow down?
CR: Despite the challenges of slowing global growth, our outlook is constructive for a number of reasons. Whenever we find what appears to be excess pessimism in the market, which is what we’re seeing in certain cyclicals today, we investigate how much of that negative perspective is already reflected in the current stock price. Currently, cyclical stocks sell at a greater discount to the Russell 2000 than they did during the fall of 2008—in the teeth of the Financial Crisis. That strikes us as excessive pessimism.
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?
CR: I’d say that the overall mood of the management teams we’ve been meeting with is constructive. Of course, most are as cautious about the uncertain pace of global growth as the rest of us are. At the same time, however, the managements for most of our holdings are fairly confident in the state of their order books. I think much of that comes from the fact that many of our companies have made contingency plans around the possibility of tariffs. They’ve positioned themselves for the unknown in what we think is a responsible and appropriate manner—which is exactly the sort of long-term planning we like to see from companies.
What is your outlook around volatility?
CR: We’ve seen some instances of increased levels for most of the last year, going back at least 10 months. In fact, there have been two spikes—a very strong burst in 4Q18 and then a less dramatic one in May. It seems to be part of the landscape now for the market to cruise forward for weeks if not months before experiencing these more volatile outbursts. In large part, I think this is a function of changes in the market’s structure, such as the increased popularity of passive strategies, trend-following algorithmic trading, and a lack of capital on sell-side desks.
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?
FG: I think everyone is concerned. The most recent research we’ve seen pegs the current risk of recession over the next year at about one in three. In spite of the inverted yield curve’s stellar predictive record, however, there’s some important additional context that suggests it could be different this time. We can look at long-term Treasury yields as consisting of the expected yield for shorter-term bonds plus a risk, or term, premium. But with inflation risk declining over the last several years, that term premium has also declined, which has led the yield curve to be more inverted than it probably would have been previously. The upshot is that the ongoing combination of easy money, low rates, and little, if any, inflation makes the predictive accuracy of the inverted yield curve a little less sure than it would be under more historically familiar conditions.
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?
FG: By leaving rates unchanged but signaling that a cut could come if conditions warrant, the Fed left the door open to future reductions based on their view of the data. There were no real surprises in what they said, which I think is healthy. The market, of course, acted as if a rate cut is imminent, or at least will happen at the first sign of a more pronounced slowdown, which is consistent with Chair Powell’s remarks. We still maintain, however, that too many investors confuse a slowing, but still growing, economy with one headed inexorably toward a recession. Each time the Fed cuts, there’s a reaction from some quarters suggesting that the central bank is sparing us from an imminent contraction whereas we see them trying to maintain or reaccelerate the growth rate.
What’s your outlook from here?
CR: Markets are very good at surprising most investors. Today, given the widespread concerns about slowing growth, increasing trade tensions, and the extended economic cycle, the most surprising outcome might be a rally. We see four favorable factors in the current market environment—low inflation, modest valuations, moderate growth, and increasing liquidity. When taken together, we see these factors as painting an attractive picture for small-cap investors. With so much attention on negative macro issues, we think investors may be missing this positive picture.
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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