Reversals and Cross-Currents in 1Q17
article 04-06-2017

Reversals and Cross-Currents in 1Q17

Portfolio Manager Chuck Royce and Co-CIO Francis Gannon recap the performance reversals and cross-currents in 1Q17 and explain why lower returns for small-caps might be the pause that refreshes.


What was your take on 1Q17?

Chuck Royce: I think what was most interesting in 1Q17 were the short-term reversals of what worked in 2016, especially in the fourth quarter. In the first quarter, we saw reversals in leadership based on market capitalization, style, and sector.

Large-caps beat small-caps, growth beat value, and healthcare stocks overcame a weak 2016 while Energy— one of the stronger areas for small-cap in 2016—fell farthest. So a lot of what worked best in 2016, especially late in 2016, did not work in 1Q17—and vice versa.

Francis Gannon: The higher returns for growth seemed to us in many ways like a validation of the high returns small-cap value stocks posted in 2016, even allowing for the fact that overall valuations were somewhat high as we entered April based on more realistic expectations.

In other words, if those returns didn't feel in some sense well-earned to investors, we probably would have seen a bigger pullback for value in addition to the catch-up for growth. That it played out the way it did, with a strong return for growth with value down just slightly, suggests to us that equities remain in basically good shape.

After the Russell 2000 Index hit a new high on 3/1/17, what leads you to believe that small-caps still have room to run?


CR: I think context is critical when thinking about the longevity of the current small-cap cycle. First, the bull market in large-cap stocks is aged. It just hit its eight-year anniversary, dating back to 3/9/09, which was the market trough following the Financial Crisis.

Small-caps bottomed on that same day, too, but the Russell 2000 Index has since had two subsequent bear markets–the first ended on 10/3/11 and the second on 2/11/16. So the current small-cap cycle, which is a little more than a year old, is quite young, especially compared to large-cap's.

FG: It's also important to keep in mind just how resilient the current rally has been, which we find very encouraging. In less than a year, the markets have been rocked by Brexit, the highly contentious election, and the false start on healthcare reform.

Yet none of these events have done more than temporarily slow the overall upward move for small-caps.


Closely related to this is the median return for the Russell 2000 following declines of 15% or more. There have been 11 since the Russell 2000’s inception in 1979. The median return in the subsequent recovery was 98.8%.

The last small-cap bear market, which Chuck mentioned, was a 25.7% drop from 6/23/15-2/11/16, and from that February 2016 bottom through the end of 1Q17, the Russell 2000 was up 47.8%. So history suggests we are less than halfway through, which means the cycle is young not just in terms of time— and in our view has room to run.

1Median includes only full recovery periods of the Russell 2000 after a decline of 15% or greater since the index's inception (12/31/1978)

Do you think small-caps could still experience a modest correction?

CR: Yes. We don't expect a significant decline or bear market for small-caps. Our estimate is somewhere in the 5-12% range.

Many investors seem concerned that the timeline for new stimulative fiscal policies may extend into 2018, tempering the postelection optimism that animated 4Q16's market. In fact, at the end of 1Q17, much of the market looked high priced enough to us and many others that the next downdraft will be one of the most highly anticipated in many years.

All of this sounds more to us like a pause in a longer bull phase than a scenario for a bear market. Instead of a broad-based pullback, we think additional rolling sector- and industry-based corrections are more likely in the months ahead, similar to what we saw for industrial stocks in 2015, healthcare in 2016, and energy so far in 2017.

FG: As bottom-up small-cap specialists, we're not as concerned as some investors are with developments in Washington, whether at the Fed or on Capitol Hill.

Our focus is on our analysis of, and communication with, individual companies, so we see the rally as having a more substantial foundation. This is why we think upcoming earnings announcements—and guidance—will play a big role in the market's moves, which is what we would want and expect in the current climate.

Psychology runs the market in the short run, but earnings run it in the long run. And this small-cap market seems to be going through a correction in time, where future earnings need to catch up to current prices.

Were you surprised that both high-quality and low-quality small-caps did well in 1Q17?

CR: Not entirely, although it was such a strong quarter for growth that it may seem a little counterintuitive that quality did so well.


However, quality companies, which we measure by high returns on invested capital (ROIC), were substantially disadvantaged, and therefore deeply discounted, by expansive monetary policy and zero interest rates from 2011-2015.

So even after last year's strong run, other investors are continuing to show interest in a number of high-quality small-caps.

FG: It's also helped that, as monetary policy moves off center stage, more attention is being paid to fundamentals such as earnings, profitability, and the ability to self-finance. This clearly helped many high-quality small-caps in 2016 and in 1Q17.

As for lower quality, I think it had to do with the ongoing success of many tech companies, which received little attention, as well as the catch-up dynamic we mentioned earlier. There's also the possibility for additional economic acceleration.

Can you expand on the performance patterns you saw in 1Q17?

CR: In our small-cap market, we noticed how narrow returns for the asset class were in 1Q17, which is often the case when growth leads. The cap-weighted Russell 2000 was up 2.5% while the equal-weighted index was up only 0.1% in 1Q17.


This suggests that the market was weaker than it appeared, which is borne out by the fact that healthcare's leadership was itself confined primarily to the sector's biotechnology, pharmaceutical, and healthcare technology areas. We certainly did not see a broad-based move for growth as a whole in 1Q17.

So it looked a lot to us like 3Q16 in that much of what worked best in 2016 as a whole—dividends and low leverage, for example—trailed in both periods. In fact, 1Q17 looked to us like a consolidating market, with laggards such as the Nasdaq, large-caps, and growth all catching up, which was the opposite of what happened in 2016.

Still, we see the cycle as a very healthy one, even with its 'two steps forward, one step back' pattern.

Why do you think small-caps are likely to see more volatility in the months ahead?

FG: The low volatility in the markets over the last few months feels like an eerie stillness, almost like the calm before the storm, especially with valuations high.

Coupled with the political volatility we've seen, the low volatility environment doesn't seem sustainable. Markets simply do not stay steady, predictable, and/or placid for extended periods.

Something has to give at some point—and with stock prices running high, it seems to us that higher volatility is likely.

How are you approaching portfolio positioning in a period of high valuations?

CR: With buying opportunities being pretty limited, we've been looking at discrete buys across disparate industries. Some have been special situations while others are companies undergoing transitions that have created what we think are attractive valuations.

Another area are firms with complex business models where we think the complexity makes it hard for most investors to gauge the profit potential. More generally, we're staying prepared for any pullback, whether in particular sectors or in small-cap as a whole, so that we can move quickly when opportunities arise.

We're also looking closely at some of our largest positions and have trimmed some of our top contributors from 2016 so that they do not become too large a percentage of a given portfolio's net assets.

We want to preserve portfolio diversity, which is an important risk management tool that assumes greater importance when share prices have been rising over an extended period.

With Health Care's rebound in 1Q17, how have you been approaching that sector?


CR: The long-term opportunities throughout the sector are very real, but we need to carefully balance valuation with company quality. In general, that's easier to do outside the more speculative bio-pharma complex, but there are still risks, especially with reforms to the Affordable Care Act still not settled. Pricing remains an open question in many cases.

In addition, valuations through much of the sector still looked a bit high to us at the end of March. I've slightly increased my exposure in some portfolios, mostly by adding to positions that are solid earners with the potential to stay that way.

It's a sector that we'll be watching closely over the next several months, especially considering that volatility has been more prevalent in healthcare stocks over the last 15 months. If that continues, we should see additional opportunities to buy at prices that look attractive to us.

Are the management teams you've met with recently feeling more confident about economic growth?

CR: We have definitely heard a tonal shift to greater optimism from many management teams since the election. As we've observed, there was a lot of data that showed the economy was improving prior to November that had been bottled up.

The good news is that even as the new Administration and Congress have hit some road bumps in terms of implementing policy, the managements are maintaining their positive perspective, even after allowing for the fact that optimism has run a little ahead of reality.

Based on what you’ve been hearing, what is your outlook for Capex spending?

FG: We're cautiously bullish. It's true that many businesses have a very real need to reinvest, particularly in technology, and have had that need for several years. Economic conditions are finally improving to the point where a robust round of spending looks feasible.

The PMI is up, the job market continues to improve, and wages are rising. So the outlook is promising. What complicates this rosy picture is the possibility that earnings improvement doesn't materialize to the degree necessary to sustain expectations. That's the air pocket—that's the distance between optimism and reality that might lead to higher levels of volatility.

What do you make of the Fed's decision to raise rates on March 15th?

FG: It was a positive sign, not just for the hike itself but also for the likelihood of two further increases later in the year. These represent votes of confidence in a growing economy.

To be sure, what might be most interesting is that when news came out earlier in March that there would likely be three rate hikes in 2017, not only was there no 'taper tantrum,' but the market basically shrugged.

The Fed's role in the economy—and in the perception of how well the economy is doing—has been diminishing, which itself is a positive sign. It shows that the condition of companies and the potential for effective fiscal policies are now more important than monetary policy.

Moreover, we would encourage anyone concerned about the effects of rising interest rates on small-cap stocks to watch a recent video we made in which we look at data showing that small-caps actually have lower interest rate sensitivity than large-caps.

Do you expect small-cap value to maintain leadership in the current cycle?

CR: Yes, we do. We expect the shift in leadership to value, which began with the June 2015 small-cap peak, to be a lasting one. It marked a genuine regime change in small-cap leadership that was accompanied in 2016 by improved results for small-caps versus large-caps and cyclical stocks.

We see no rotations in long-term sector or style leadership and expect that the three reversals from 2016 that we've been emphasizing—positive long-term returns for small-cap, value leading growth, and cyclicals beating defensives—will remain in place.

As far as value's leadership is concerned, it's worth noting that at the end of the quarter the Russell 2000 Value was still 200 basis points behind the Russell 2000 Growth on an annualized 10-year basis despite having a historical advantage of 410 basis points over all 10-year monthly rolling periods.

FG: We expect that the small-cap market will resume its advance later this year. The basically flat market from the 2016 high on 12/9 through 3/31/17, in which the Russell 2000 was up 0.3%, may have been the small-cap pause that refreshes.


After all, the economic news remains positive here in the U.S. and is improving globally, and it shouldn't take much acceleration to help stocks. The small-cap earnings outlook remains decent to bright, depending on the industry, as do the prospects for margin expansion. The dollar corrected slightly in 1Q17, which is a good sign for many small-cap companies and, while rates are rising, yields have so far not elevated too quickly or too high.

Value stocks have also historically outpaced growth issues when the economy is expanding while also showing less sensitivity to rising rates than their growth counterparts. So while we're not expecting returns to move in a straight lineup, we think it's likely that small-caps have room to run.

Important Disclosure Information

Mr. Royce’s and Mr. Gannon’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of small-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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