Co-CIO Francis Gannon on why the last 90 days’ of small-cap returns may have more to do with investors’ moods than fundamentals.
Q4 hedge fund letters, conference, scoops etc
After losing 22.1% from 8/31/18-12/31/18, the Russell 2000 Index looked poised for some kind of rebound as we entered 2019, but we think it’s fair to say that few were expecting the kind of broad-based, double-digit rally we’ve seen before March even began.
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However unanticipated, this is where we find ourselves, with the Russell 2000 up 17% through 2/28/19—a result that’s more than high enough to be a good calendar year’s performance.
We’ve been struck by the strength of 2019’s YTD returns, especially coming so closely and quickly on the heels of 2018’s decline. After all, as last year’s holidays approached, the market seemed convinced that the U.S. economy was careening headlong toward a recession.
So far in 2019, however, the market seems to have shed most if not all of those concerns. Over the last seven or eight months, we’ve seen three different market moods: late last summer, extended valuations for small-cap stocks seemed well out of sync in light of the index’s high levels of debt and low profitability; then, at the end of 2018, valuations appeared to have absorbed an ample dose of excess pessimism (at least in select instances); and now, almost suddenly, many of those same valuations have increased markedly.
These abrupt shifts would be odd enough on their own, but they’ve arrived at a time when the economic signals continue to be mixed, though with most signs pointing to slower—but still positive—growth in the U.S. China, Europe, and Japan continue to show weakness and may have reached, or be reaching, bottoms. Should the world’s other key economies begin to grow again, it would in all likelihood be good news for many U.S. companies, particularly for those economically sensitive cyclical businesses with a global reach, and we hold many that fit this profile.
With the absence of any major events, then, the pattern looks to us like a classic instance of a short-term mood swing, with investors buying, selling and then buying again in what strikes us a distinctly hurried fashion.
In any event, not a lot has tangibly changed on the macro side since the beginning of the new year. Certainly nothing that would suggest the radical changes of direction we’ve seen since small cap peak in August, with the possible (and significant) exception of the Fed stressing in January that it would move cautiously and in February that it would hold rates steady for the intermediate term.
With the absence of any major events, then, the pattern looks to us like a classic instance of a short-term mood swing, with investors buying, selling, and then buying again in what strikes us a distinctly hurried fashion. The market appeared to be trying to price in an imminent contraction in economic growth before just as speedily deciding that a recession was not likely.
So while the market’s moves recent have been jarring, their current state squares with our assessment of the state of play at the end of 2018, when it seemed to us that December’s wave of indiscriminate selling revealed a disconnect between the operational success many companies were experiencing that was in stark contrast to the negative mood of investors.
From our perspective, then, small-cap valuations are now closer to where they were at Halloween than at Christmas (which was actually the scarier holiday for investors in 2018). We think that the market’s trajectory from the end of December through the end of February can best be seen as a shift in sentiment, in which recent gains compensated for the earlier overreaction to economic data and/or Fed announcements that were clearly not as bad as were first assumed.
So our outlook remains the same. We expect slower but positive economic and corporate profit growth—possibly bolstered by recoveries outside the U.S. Additionally, we see little possibility for multiple expansion, and in our view this will likely result in lower (as in high single digits) overall small-cap returns as well as the possibility of increased volatility. As we’ve noted previously, lower-than-average returns for small-cap stocks have typically been good times for active management approaches, including a number of our own strategies, especially following deep market declines.
Stay tuned…
Article by The Royce Funds
