3Q23 Small-cap recap

Equities struggle as yields climb in 3Q23

The major US stock market indexes were down across the board in 3Q23, thanks to a combination of revived recession warnings, rising yields, and a looming government shutdown. The 10-Year Treasury yield rose to 4.6% in September, climbing by more than 20.0% in 3Q23 to its highest rate since October 2007. And even with Google and Amazon facing anti-trust suits, small- and micro-cap stocks bore the brunt of the quarterly downturn. The Russell 2000 Index fell -5.1 % in 3Q23 while the Russell Microcap Index lost -7.9% compared to respective losses of -3.1% and -2.8% for the Russell 1000 Index and mega-cap Russell Top 50 Index. In fact, the Russell 2000 fell -10.6 % in August and September alone.

This reinforced a stubborn pattern of small-cap underperformance that has been in place for several years and has been consistent so far in 2023. For the year-to-date period ended 9/30/23, the Russell 2000 was up 2.5%, and the Russell Microcap was in the red at -5.8%, while the Russell 1000 was up 13.0%—and the mega-cap index nearly doubled that return with a year-to-date gain of 24.3%.

The Russell 2000 thus finished September 1,047 basis points behind its large-cap sibling. The end of September also marked the biggest 1-year spread between the Russell 2000 (+8.9%) and the Russell Microcap (-1.3%) since the latter’s inception in June 2000. Equally important, the Russell 2000 slipped back into bear territory in 3Q23, down -24.8% from its last peak on 11/8/21, putting the asset class into a nearly 2-year bear cycle while large caps experienced only a minor loss through this lengthy small-cap correction.

Non-US indexes did not fare much better, for understandable reasons—China and Europe remain in various stages of recession or markedly slower economic growth. However, the MSCI ACWI ex-US Small Cap Index lost only -1.7% in 3Q23 while the MSCI ACWI ex-US Large Cap Index fell -4.1%. For the year-to-date period ended 9/30/23, the two indexes were nearly even, with the non-US small-cap index gaining 5.0% and its large-cap counterpart up 5.3%.

The small-cap seesaw

As might be expected in a down quarter, the Russell 2000 Value Index lost significantly less than the Russell 2000 Growth Index, down -3.0% in 3Q23 versus -7.3%. The small-cap value index still trailed on a year-to-date basis, down -0.5% versus a gain of 5.2%.

Over longer-term periods, the relative advantage switched around a bit, with the small-cap value index winning for the 3- and 5-year periods while the growth index won for the 1- and 10-year periods ended 9/30/23. One element that has not changed, however, is the absolute and relative valuation of small-cap value. Using our preferred index valuation metric of enterprise value over earnings before interest & taxes (EV/EBIT), we can see that the Russell 2000 Value remained attractively valued at the end of 3Q23, particularly relative to the Russell 2000 Growth.

Similarly, the Russell 2000 Value finished June much more attractively valued than the Russell 2000 Growth, based on the same EV/EBIT metric.

As might be expected, the Russell 2000 was far more attractively valued at the end of September than the Russell 1000, based on the same EV/EBIT metric.

The small-cap sector story

In light of the widespread attention on AI, as well as the coming impact of the CHIPS and Science Act, it was somewhat surprising to see Information Technology stocks hit hard within the Russell 2000 in 3Q23. Along with Health Care—another locus of innovation—the tech sector had the sharpest losses and the biggest negative impact on small-cap results in 3Q23. All told, only Energy and previously beleaguered Financials finished the third quarter in the black, though double-digit losses on a sector basis were limited to Health Care and Information Technology. Along with the US dollar, energy and financial stocks offered one of the few attractive investments for 3Q23. These widespread sector declines created a number of interesting long-term buying opportunities.

The active opportunity

Of course, we view performance over much longer time periods than the just concluded quarter—and much of what we see skews positive over the long run. First, in the 18 months that followed the first Federal Reserve (Fed) rate hike in March of 2022, the Russell 2000 was down -10.0% while the Russell 1000 was marginally positive at 0.3%. Yet history shows that 1- and 3-year returns for both indexes were mostly positive following the nine previous initial tightenings by the Fed. This recent departure from the historical pattern suggests to us that the market may have already priced in a potential recession—and that higher small-cap returns may be on the horizon.

Another historical pattern that has so far not materialized is the relationship between small-cap performance and high-yield credit spreads. When the latter contract, as they have been doing since peaking in July of 2022, small-cap stock prices typically rise. High-yield spreads have fallen 2000 basis points over the last 14 months. From 7/31/22-9/30/23, however, the Russell 2000 fell -3.5%. The last time high-yield spreads experienced a fall from a similar level with a comparable decline was from 7/31/20-12/31/20—and the Russell 20000 climbed 34.1% over that brief five-month span.

While these historical patterns are of great interest to us, we are more encouraged by the combination of valuations and long-term opportunities. The Russell 2000 finished September 2023 with a 2.4% 5-year annualized return—a performance nearly identical to its year-to-date result through the end of 3Q23 and evidence of just how underwhelming recent returns have been for the small-cap index. (To be sure, we are very pleased that performance of our own disciplined and active domestic Strategies has been far better.) Yet the average price to earnings ratio for the Russell 2000 five years ago on 9/30/18 was 18.4x—close to its long-term average of 18.1x—versus 12.5x at 9/30/23. While returns have stalled, multiples have compressed, creating a considerable number of buying opportunities.