Can the rally keep running?

Small-cap stocks

Can the rally keep running?

History suggests that small-cap stocks may have more room to run, but some companies appear better positioned to lead than others.


1Q19—A Welcome Rebound

Small-caps came roaring back in 1Q19 (along with the rest of the U.S. stock market), as the Russell 2000 Index gained 14.6% for the quarter. The upswing followed on the heels of a dismal 4Q18, when small-caps fell 20.2% (and were down 11.9% in December alone).

 

Source: Bloomberg, as of 3/31/19. 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 charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

In the midst of December’s steep downdraft, it looked to us as if the market was experiencing something like a manic episode. As we observed at the time, it appeared that market sentiment had become detached from company fundamentals, creating an opportunity for selective patient investors. The rally that kicked off 2019 was the reversal of this dynamic.

Robust Recovery

While the rebound itself was unsurprising, though no less welcome, its combined strength and speed were more of a surprise. Following the first day of a decline of at least 20%, the average three-month recovery for the Russell 2000 has been a gain of 8.4%, and the small-cap index gained 12.2% from 12/17/18, the first day following its 20% decline, through the end of March.

Although the Russell 2000 also made up more than half of the ground it lost from its most recent (and all-time) high on 8/31/18 through 12/24/18, the index still finished 1Q19 10.8% shy of that peak.

1Q19 Flips the Script

With China flirting with recession, Europe weak, and the U.S. economy slowing, it made sense that small-cap market leadership came mostly from high growth stocks in 2019’s opening quarter rather than economically sensitive value stocks.

In fact, the performance pattern of 1Q19 basically flipped the script from 4Q18: growth beat value, non-dividend payers outpaced dividend payers, and non-earners (companies with negative operating income) gained more than earners. The exception in 1Q19 was that defensives slightly outpaced cyclicals, driven by strong performances from high-growth areas like software and the bio-pharma complex.

 

Source: Bloomberg, as of 3/31/19. 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 charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Sectors Show Mixed Signals

There was an interesting mix of results at the sector level. Information Technology and Energy led while Consumer Staples and Financials were the biggest laggards, though each had a positive return.

Energy recovered from a highly forgettable 2018, when it was the worst-performing sector in the small-cap index, while Information Technology saw broad-based strength from the high-growth software group while also getting benchmark-beating performance from cyclical areas that we like, such as electronic equipment, instruments & components and semiconductors & semiconductor equipment.

The lag for Financials came from its two largest industries—banks and insurance, both of which were negatively affected by the Fed pivot to holding the line on further interest rate hikes.

Stranger Things

There were also a couple of counterintuitive developments in 1Q19. In a broad rally that saw all 11 Russell 2000 sectors finish March in the black and cap-weighted and equal-weighted small-cap returns very close—the equal-weighted return for the quarter came in at 13.7%—only 77% of the companies in the index had positive returns.

This percentage looks low to us in light of the fact that 89% of the index’s companies had a negative return in 4Q18. Of course, this also suggests that attractive opportunities may be found within that 23% of stocks, where recent negative returns have created low expectations.

What’s Next for Small-Cap Returns?

In this context, the obvious query is, “What’s next?” The question becomes even more interesting in the context of small-cap history.

The Russell 2000 has had 10 declines of 20% or greater in its more-than-40-year history. Small-caps enjoyed positive 12-month returns in nine of the subsequent 10 periods following the first day of the 20% decline (the exception was the period following the Financial Crisis); eight had returns in excess of 10%, and five of those had 12-month results of more than 20%.

Cumulative 24-month returns following these 10 declines were also encouraging. Nine periods had positive performance (the exception again being the period following the Financial Crisis), with eight of the nine spans having a two-year cumulative return of at least 30%.

Strong Small-Cap Recoveries

Subsequent Cumulative 2-Year Russell 2000 Returns Following Declines of ≥20% (%)

Source: Bloomberg, as of 3/31/19. 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 charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

All of this suggests that the rally has room to run even with the possibility that gains could be consolidated over the next several months given the strength of 1Q19’s performance.

A Question of Leadership

As we look forward, then, some matters appear clearer to us than others. History certainly suggests that stocks have more running room in their recovery from 2018’s second-half decline, though it’s less clear to us where small-cap leadership will come from in this next phase.

One can certainly make the argument that environments with slow economic growth and low interest rates are usually favorable for growth stocks. However, the expectations for these stocks also look unsustainably high to us, especially with the possibility of increased global regulation for technology behemoths and potential price controls of pharmaceuticals.

Many small-cap cyclical businesses, on the other hand, look more reasonably priced to us than their high-growth counterparts as measured by EV/EBIT (Enterprise Value/Earnings Before Interest and Taxes). Equally if not more important, cyclicals are also trading at a 10% discount to the overall Russell 2000 (again as measured by EV/EBIT)—which is their deepest discount in 20 years. And some of these same companies offer what we see as a winning combination of high ROIC, attractive cash flow characteristics, low expectations, and/or the potential for earnings growth.

We are working to take advantage of a market that seems unconvinced about the possibility of economic reacceleration, even as the developed world’s central banks seem prepared to use all of the monetary tools at their disposal to sustain or reignite growth.

This leaves us in the position of liking many of the valuations that we’re seeing, where our selective optimism contrasts with what we view as excessive pessimism from other investors.

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: (98) Jin Guan Tou Gu Xin Zi Di 001; 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.

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

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.