Q2 review: A Typical Rebound in Atypical Times

Royce Investment Partners: After a big second quarter rebound, what’s next for small-cap stocks?

    Francis Gannon

    Francis GannonCo-Chief Investment Officer, Managing DirectorRoyce Investment Partners

    Global equity markets enjoyed a remarkable recovery in 2Q20, coming back strong following mid-March bottoms that resulted from COVID-19-driven lockdowns. The small-cap Russell 2000 Index rose 25.4% for the quarter, going from its worst quarter ever in 1Q20 to one of its three best quarters since its inception more than 40 years ago.

    In spite of ongoing volatility and considerable economic anxiety, stocks behaved in a fashion consistent with historical rebounds in recessionary periods. The global health crisis was undoubtedly an unprecedented cause for the market’s decline, but the subsequent pattern for equities was very much in line with history: Micro-caps beat small-caps, which in turn outpaced large-caps. The recurrence of this familiar recovery pattern gives us a measure of confidence amidst the ongoing short-term uncertainty.

    Mirror Images: 2020 Quarterly Returns by Market Cap2Q20’s gains were nearly the reverse of 1Q20’s losses

    Source: Bloomberg, as of 6/30/20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    There were additional examples of the reversal from 1Q20 to 2Q20. The sector leaders and laggards reversed as well, with Utilities moving from first to worst while Consumer Discretionary traveled in the opposite direction, going from second to the bottom to the top-performing sector.

    Familiarity in Strange Days

    We are also encouraged that the anomalies in the current period have so far been limited first to the global health crisis that precipitated the bear market and second to the extraordinary speed with which shares both fell and rose. In addition to the historically familiar market cap array of returns, other factors, including cyclicality and perceived riskiness, performed as we would have expected in 2Q20: cyclicals beat defensives, higher-leverage stocks outperformed lower-leverage issues, low quality (as measured by return on equity) edged high quality, and non-dividend payers outpaced dividend payers.

    In the early days of the decline, investors seemed to be most worried about the state of the global economy and financial system, the latter grounded in painful memories of the Great Financial Crisis. By providing ample liquidity, the Fed worked to quickly defuse the latter concern, which helped the market to begin stabilizing in mid-March. This was followed by economic news that, while not positive, was far less worrisome than had been anticipated, and this drove the recovery from roughly mid-May on. May’s change in investor perception keyed a leadership shift in small-cap as cyclicals took over from defensives from that point.

    Intra-Quarter Leadership Shift: Cyclicals vs. DefensivesRussell 2000 cyclicals trailed early but came back strong to outpace defensives in 2Q20

    Source: Bloomberg, as of 6/30/20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    The strength of the recent upswing has given some investors pause. They wonder how stock prices can be climbing when the economy still appears to be in rough shape. Yet this is also historically consistent. The market typically looks forward, being more focused on the days ahead than on the present. This was the case in 2009, when stocks bottomed in March while the recession did not end until June of that year.

    Whither Value?

    One curious exception to the otherwise historically conventional market behavior in 2Q20 was value, which underperformed significantly across the market cap spectrum from micro- to large-cap. Value lost ground to growth during the recovery as well as in the decline. Recent underperformance extended disappointing relative results for value over much of the past 10 years, 2016 being the exception.

    This persistent underperformance has reversed a pattern that has held since the 1980s, when value routinely outperformed growth over three-year or longer periods. Some of this underperformance can be explained by unfavorable environments for value stocks, specifically the low interest rates and slow, steady economic growth that have tended to provide tailwinds for growth stocks and headwinds for value. More fundamental reasons have also made an impact as the asset-heavy business models that have greater weighting in the value universe remain out-of-step with an economy in which rewards are increasingly bestowed on ideas and/or asset-light businesses. Yet while the outlook for the overall small-cap value universe is mixed, there is a selection of very attractive undervalued opportunities for active managers.

    A Look Ahead: Divergence Might Generate Opportunity

    Also of interest is that the Russell 2000 remained well below its August 2018 peak—by 14.9%—at the end of June while the Nasdaq established new highs. We think this divergence is significant in that some investors may be hesitant to invest in small-caps in the mistaken belief that the asset class has peaked. While other parts of the market look overheated, small-cap does not, particularly when one looks at individual small-cap companies.

    A comparison with the recovery from the two most recent steep small-cap declines in 2000-2002 and 2007-2009 may also be helpful. In the subsequent two-year periods following the trough in those two declines, small-caps advanced 80.4% and 145.6%, respectively. These gains significantly exceed the 46.0% return for the Russell 2000 from the 3/18/20 low through the end of June. Based on both history and the current market cycle, therefore, it looks as though small-cap stocks have room to run.

    Small-Cap’s Bear-Market ReboundsReturns for the Russell 2000 have been historically strong coming out of significant bear markets

    Source: Bloomberg, as of 6/30/20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    Notwithstanding our optimism about the prospects for select small-caps, we also expect volatility to remain elevated in the current period of intensified uncertainty. The average daily VIX has stayed north of 30, a high historical level, in each of the last four months. This volatility may take the form of occasional dramatic spikes based on headline news relating to COVID-19 or economic data, as has been the pattern over the last several months. Increasing attention on the November elections and their consequent potential policy shifts—especially regarding the regulation of mega-tech giants such as Facebook and Google—are also likely to create increased volatility in the months ahead.

    Foggy Short-Term Views versus Long-Term Clarity

    To be sure, the short-term outlook over the next six to nine months is uncommonly occluded. It’s therefore not surprising that so many people seem to be investing based primarily on headline news, not appearing to give much thought to any period beyond the end of the year.

    Long-term thinking in a short-term world has traditionally offered disciplined active managers an advantage over the ensuing three to five years. It’s also important to remember that small-cap has enjoyed positive returns over three-year or longer periods the vast majority of the time. As measured by the Center for Research into Security Prices, small-caps have had positive results in 88% of the rolling monthly three-year periods and 95% of rolling monthly five-year periods ended 5/31/20 since 1945.

    Not as Risky as You Think% of Positive Monthly Rolling Return Periods for Small-Cap Stocks from 12/31/45-5/31/20

    Source: Bloomberg, as of 6/30/20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Number of monthly rolling periods where the Small-Cap CRSP 6-10 has a positive return: 3-Year (756 out of 858), 5-Year (793 out of 834). Number of monthly rolling periods where the Large-Cap CRSP 1-5 has a positive return: 3-Year, 88% (759 out of 858), 5-Year, 93% (775 out of 834).

    If we assume for the moment that the small-cap low in March 2020 holds, we see considerable potential for the strongest, best-managed small-cap companies to grow stronger coming out of the current globally challenging situation and enjoy success in the years ahead. This includes companies involved in e-commerce, the Internet of Things, and work-from-home technology, often in semiconductors and related components businesses. We also like companies that manufacture RV and boating components, which are benefiting from changes in travel and vacation habits where physical distance is needed. Additionally, we see companies involved in M&A and corporate restructurings as very well positioned for an acceleration of growth over the intermediate term.

    Recent volatility and the uncertain outlook might cause investors to hesitate before investing in small-caps. In contrast, we would suggest looking forward to the years ahead. While the shape and timing of the recovery are unknown, we believe that small-caps are likely to have higher profits—which have historically been reflected in higher stock prices. Investors with the discipline and patience to invest in small-caps now could be rewarded in the years to come.


    A bear market typically describes a condition in which securities prices fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment.

    The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.

    COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARS­CoV-2.

    The (Center for Research in Security Prices) CRSP (Center for Research in Security Pricing) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000.

    A cyclical stock refers to an equity security whose price is affected by macroeconomic, systematic changes in the overall economy. Cyclical stocks are known for following the cycles of an economy through expansion, peak, recession, and recovery

    A defensive stock is a stock that provides a constant dividend and stable earnings regardless of the state of the overall stock market. Defensive stocks tend to perform better than the broader market during recessions. However, during an expansion phase, they tend to perform below the market.

    The Federal Reserve Board (Fed) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

    The Great Financial Crisis (GFC), also known as the financial crisis of 2007–08, the Great Recession, global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.

    Growth refers to stocks of companies whose earnings are expected to grow at an above-average rate relative to the market. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects.

    Leverage refers to the amount of debt held by a company or sector of the market.

    Mergers and acquisitions (M&A) is a general term used to refer to the consolidation of companies. A merger is a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed.

    Return on Equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder's Equity.

    The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

    The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

    The Russell Microcap Index measures the performance of the microcap segment of the U.S. equity market. Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smallest eligible securities by market cap.

    RV is an abbreviation for Recreational Vehicle.

    Value stock refers to the stock of a company that is believed to trade at a lower price relative to its fundamentals (i.e. dividends, earnings, sales, etc.).


    Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.