How Could Small-Caps Surprise?

How Could Small-Caps Surprise?

Co-CIO Francis Gannon discusses the ongoing consolidation in small-caps, while also touching on earnings, valuations, and the prospects of a pick-up in volatility.


What is the current state of small-cap stocks?

So it's been a very interesting, I think, first half year in the small-cap market. We've seen various highs in the market. We've seen pullbacks in the market. The biggest pullback we've seen is just under five percent. We're at a moment in time where I think we're at a bit of a crossroads in the small-cap space. Either the market is going to break out of this consolidation, or have a correction. And you could argue either one. Historically, you would have seen at least a ten percent correction annually in the market. We haven't seen that yet this year.

And the biggest surprise to me going forward is that you could see earnings actually do much better than people anticipate within the small-cap space. Part of this is driven by the fact that a year ago, people forget, we were just coming out of a profit recession. So we have very easy comparisons from an earnings perspective.

By the same token, you are seeing the beginning of a synchronized global economic pickup, which I think is going to really help the earnings in certain areas of the small-cap market. It might not help the overall market from a small-cap perspective, but you could see a pick-up in earnings power in many economically sensitive or cyclical businesses. That being said, could we have a correction? Yes, we could have a correction.

The surprising factor and I don't think people really thought about this either, is the fact that small-caps, at the end of June 2017, are cheaper than where they were at the beginning, in January of 2017, i.e., the forward P/E of the Russell 2000 was 20.1x on 12/31/16 and 19.4x on 6/30/17.

Earnings are much better and stronger than people realized. And so actually multiples have come down. Our job is not to focus on the valuation of the overall market. Our job is to focus on the valuations of our underlying businesses and the success and stability of those businesses.

But I think we're going to see earnings continue to grow, or companies continue to grow into their multiples because of earnings, and therefore the market has the possibility of breaking out from here.

Why does higher volatility look likely?

Volatility should pick up here. You know, part of what we've been talking about here for a very long period of time is this return to normalization, both from a fixed income standpoint or a rate perspective, but I think also you're going to see it from a volatility perspective as well. We have had increased volatility around specific events over the past several years.

 

Year to date volatility is lower than avearge

CBOE Russell 2000 Volatility Index (RVX)

Source: Bloomberg, as of 6/30/2017. 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. 

 

We had it around Brexit, we had it around the election in 2016. My sense is that you're going to see an increase in volatility as the year goes on, which I think is healthy, especially as an active manager, we're going to be able to find our spots in particular sectors of the market.

What do you think about the small-cap consolidation?

So the small-cap market has been in a consolidation phase, if you will, really since December of last year. And what I mean by that is we've had periodic highs in the market, but we've also seen the market pull back from those highs.

 

Small-cap cool down

Russell 2000 cumulative returns

Source: Bloomberg, as of 6/30/2017. 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 biggest decline we've seen is about 4.7 percent. But we had new highs around April 1st of this year. We've had new highs in June, but the market sells off after we have these new highs. Now that being said, we've lived in a market where we've seen five consecutive quarters of the Russell 2000 being up, right?

The most recent quarter, the second quarter of this year, we were up two and a half percent. The first quarter of this year we were up two and a half percent. So we're up about five percent for the year.

Why do I say we're consolidating? I still believe that since December 9th of last year, through the end of the first quarter, the market really hasn't done anything significant. And what you're seeing at the beginning of the year was a rotating correction through a variety of different sectors.

The year has been very much growth-led, where you've seen the growth year areas of the market, specifically technology and health care, led by biotech do better, along with some of the more defensive areas, as we've seen the yield curve come, come down a little bit and invert a little bit in the latter part of the first half of the year.

But what you're seeing to me is a consolidation, which I think is quite healthy. There've always been two types of corrections in the market, when I think about them. Both price and time.

We've been in a time correction in the small-cap space, which I think is very healthy, and it's one that I think is being missed by investors, who are looking for an opportunity to get into the small-cap space. We've traveled a lot around the country visiting investors this year, and I would tell you that many people are waiting for the big pullback and they're missing it. They're missing this consolidation which could possibly be the pullback in the overall market.

 

Top

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

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.

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.

Active management does not ensure gains or protect against market declines.

Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.