Royce Investment Partners Comm –


After stock prices fell volatilely in the first six months of 2022, the third quarter saw a spirited but ultimately short-lived rally that ran through July and into mid-August. before the decline days returned, reversing its midsummer gains. Unlike large caps, however, small caps did not hit a fresh low in 3Q22 as the 6/16/22 low held despite the 8/15/2000 Russell 2000 down 17.5%. /22 to 30/09/22.

A quarter up and down for small caps
Cumulative returns for the Russell 2000, 6/30/22-9/30/22

Past performance is not indicative of future results.

For 3Q22 as a whole, the small-cap Russell 2000 Index was down 2.2%, ahead of its large-cap sibling, the Russell 1000 Index, which was down 4.6% for the same period. Outside the United States, the ongoing slowdown was more evident, largely related to the sharp rise in the US dollar. Thus, while the MSCI ACWI ex USA Small Cap index was down 8.4% in 3Q22 and the MSCI ACWI ex USA Large Cap index was down 9.9%, local currency returns posted losses. lower.

Negative third quarter performance contributed to near record losses for small and large cap indices in the first nine months of a calendar year, with the Russell 2000 down 25.1%, while the Russell 1000 fell 24.6%. The negative results were the second-worst first nine months for the small-cap index (by just one basis point) and the large-cap index since their inception in 1978.

Rollovers in the Mini Rally

The Russell 2000 Value Index lost more than the Russell 2000 Growth Index in 3Q22, down 4.6% vs. gaining 0.2%. The lag in small cap value reversed the previous trend – prior to 3Q22, the Russell 2000 Value had beaten the Russell 2000 Growth for seven consecutive quarters. Additionally, the brief rally and the quarter as a whole were dominated by lower quality small caps: companies with negative earnings before interest and tax (EBIT) outperformed those with earnings, while dividend payers lagged. underperformed the non-dividend payers. This trend contrasts with the higher quality small caps leading in the first half of 2022.

Notwithstanding the third quarter results, we believe small cap value will regain its historic long-term edge over its growth counterpart. For reference, as of 12/31/21, the five-year annualized average annual return for the Russell 2000 Value was 9.1% versus a gain of 14.5% for the Russell 2000 Growth or a gap of -5.4 % for value. With the significant growth underperformance so far this year, the spread has contracted significantly for the five-year period ending 9/30/22, when the Russell 2000 Value rose 2.9% against 3.6% for the Russell 2000 Growth. One of the reasons we expect the stock to resume its outperformance against its growth counterpart is that over all five-year monthly moving average periods since inception (12/31/78), the The advantage was decidedly in favor of value, 11.9% versus 8.9%.

Small cap value regains its long-term performance edge
Five-year return differential for Russell 2000 Value versus Russell 2000 Growth


1Average Monthly Rolling Yield Spreads
Past performance is not indicative of future results.

A hawkish Fed sparks fears of recession

Investors across all asset classes have faced a host of uncertainties (many of which are interrelated) for most of 2022, including inflation, ongoing supply chain issues, variants of Covid underway, a sluggish Chinese economy and the war in Ukraine. The Fed’s decidedly more hawkish stance has been even more consistent, as evidenced by three 75 basis point rate hikes and its stated intention to keep raising rates until the fed funds level hits 4.6. % in 2023. One consequence of these Fed actions is that many investors now see a recession for the U.S. economy as a moment, not an if, and are increasingly concerned about the duration and the depth of a contraction.

Actions looking for direction

As always in a declining market, anxious investors also want to know if the markets have bottomed out. These are not questions we (or anyone else) can answer. What we can do is offer ultimately hopeful observations, knowing that stocks may not change direction in the near term. First, the average Russell 2000 stock was down 45% from its respective 52-week highs through the end of September. It was only during the financial crisis of 2008-09 and the depths of the Covid decline that the losses for mid to small cap stocks were greater. This data inspires our belief that we are likely in the latter stages of the current bear market, although we do not know when stock prices will begin a more sustainable recovery.

We also see an advantage for small caps over large caps. Compare the small-cap mid-stock’s decline with the Russell 1000 mid-stock’s 36% decline from its respective 52-week highs. Additionally, the Russell 2000 fell 31.2% from its 11/8/21 high to its 2022 low on 6/16/22. The Russell 1000 lost significantly less from its 03/01/22 high to its 2022 low on 09/29/22, down 24.6%. Additionally, the Russell 2000 entered a “classic” bear market, i.e. a decline of 20% or more from a previous high, in January 2022, while the Russell 1000 only reached a comparable fall from its peak as in September 2022. In other words, it seems to us that large-cap stocks are more vulnerable to further declines than their small-cap counterparts. Finally, measured by enterprise value divided by earnings before interest and tax (EV/EBIT, one of our favorite valuation metrics), the Russell 2000 ended 3Q22 at a much more attractive price than the Russell 1000.

Are large caps vulnerable to further declines?
As of 09/30/22


2Enterprise value divided by earnings before interest and taxes.
Past performance is not indicative of future results.

What did low single-digit long-term returns signal?

One of our biggest sources of confidence in future returns comes from the particular state of long-term small cap performance at the end of September. For the periods ending 9/30/22, the three- and five-year annualized returns of the Russell 2000 were 4.3% and 3.6%, respectively. These respective long-term yields were well below their three- and five-year monthly moving averages since the launch of the Russell 2000, which were 10.8% and 10.5%, respectively. The three- and five-year periods have not had returns at or below these levels since March 2020 and June 2009.

Why is this important? The historical small cap return model shows that periods of below average performance have been followed by periods of above average performance, with a much lower than average frequency of periods of negative performance. Specifically, subsequent small cap three-year annualized returns from comparable low-yielding entry points have been positive 97% of the time, i.e. in 30 of 31 annualized three-year periods, since the launch of Russell 2000, an average of 11.9%.

97% of the time, positive 3-year returns followed low-yielding markets
Subsequent 3-year average annualized returns for the Russell 2000 Following 3-year annualized return ranges of 0-5% from 12/31/78 to 9/30/22


Past performance is not indicative of future results.

As painful as investing during tough times can be, we believe investors should consider engaging in some form of periodic fixed-money buying. It’s easy to forget that given the historically cyclical nature of markets, markets are de-risked because they experience negative returns. And as we pointed out earlier, market rallies tend to happen quickly. A significant portion of an investor’s returns can be wasted trying to time a dip or sit on the sidelines during a bear market. Additionally, stocks historically started to rally before signs of a rebound in the economy became clear. So there are similar risks for investors trying to wait out a recession before re-entering the market. So our advice remains the same as it has been for many years: follow the old investment adage of being fearful when others are greedy, and greedy when others are fearful.

Thoughts regarding recent market movements and future prospects for small cap stocks are solely those of Royce Investment Partners and, of course, there can be no assurance as to the future performance of the small cap market. Past performance is not indicative of future results. Historical market trends are not necessarily indicative of future market movements.


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