article 02-02-2016

Are Small-Caps Experiencing a Change in the Weather?

As parts of the U.S. (including Royce's NYC offices) moved from a near-record-setting snowfall to spring-like temperatures in the space of a week, CEO Chuck Royce asks whether 2016's downturn is signaling a similar dramatic change for small-cap stocks.

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I think so. In fact, as I write this entry in early February, New York City is enjoying spring-like temperatures. Yet little more than a week ago, Central Park received more than two feet of snow in less than 24 hours.

Like the weather, the stock market seems to have changed in the proverbial New York Minute, with January being an extraordinarily volatile and bearish month by any standard. The price of oil, still-plunging and unpredictable, seems to set the stage for each equity trading session—and the commodity has continued to make new lows as the new year rolls on.

As small-cap specialists, however, we have found other developments that look more interesting—and may be more indicative of the market’s ultimate trajectory over the next several months. This has been the relative behavior of various sectors, industries, and companies from across the spectrum.

For the first time in many months, positive days for small-cap stocks (and there have been a few) have seen leadership from stocks outside the bio-pharma areas.

During January, Health Care suffered double-digit losses, the largest on a sector basis within the small-cap Russell 2000 Index. At the same time, more economically sensitive sectors in which many Royce portfolios have significant exposure, such as Consumer Discretionary, Information Technology, and Industrials, have held up noticeably better. Each of these sectors lost less than half of what Health Care did in January.

This has created conditions that so far—and I want to emphasize the short-term nature of all this—are favoring more qualitative, and valuation-sensitive approaches. At Royce, we own many companies that are holding their value better than the bulk of their small-cap peers.

This can also be seen in the monthly outperformance for the Russell 2000 Value Index, which was down 6.7% in January while the Russell 2000 Growth Index lost 10.8%.

More important, the one-year returns for the three indexes were remarkably close. For the one-year period ended January 31, 2016, small-cap value was down 9.9%, essentially even with the Russell 2000 while the Russell 2000 Growth fell 10.0%.

This is in stark contrast to returns for the one-year period ended December 31, 2015—the Russell 2000 lost 4.4% while small-cap value was down 7.5% and small-cap growth was down 1.4%

My contention for some time has been that we would see mean reversion in favor of small-cap value. After small-cap growth finished 2015 with an edge in seven of the last 10 calendar years, the result was a historically wide margin of outperformance for growth on a trailing 10-year basis through the end of 2015.

Yet I suspect that returns through the end of January are starting to establish a reversal in favor of small-cap value going forward.

So far, in spite of the highly challenging downturn, I like much of what I see. The dynamics behind the current uncertain state of stocks are the result of changes that have been percolating for the last few years. I think they signal a return to a market in which financial health and profitable execution are key drivers of returns.

Important Disclosure Information

Chuck Royce is CEO and Portfolio Manager of Royce & Associates, LLC, investment adviser to The Royce Funds. Mr. Royce’s thoughts and opinions expressed in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

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 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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