Trade tensions and signs of a slowing economy are mounting, and as a result it seems as if economic uncertainty is intensifying by the day. Without question, the economic news flow has been disappointing of late, be it sharp declines in consumer sentiment and confidence, higher inflation expectations, falling manufacturing new orders, or the lowest level on record for pending home sales, to name just a few. Throw in the daily barrage of headlines surrounding new tariffs being implemented or delayed/postponed, along with increased corporate and federal layoffs, and we have the perfect recipe for a correction. In fact, the Russell 2000 Index has declined -17.0% from its most recent high on 11/25/24 through 3/10/25. The question remains, will this economic growth scare, or possible recession, alter our belief here at Royce that the market should continue to broaden out?

From our perspective, we remain confident that a broadening of the market is at hand. The Russell 2000 was negative over the past four years, with an annualized return of -1.7% from 3/10/21 through 3/10/25, while the Russell 1000 Index has averaged 10.2% over the same period. Smaller companies have been out of favor, and while the uncertainty of today’s headlines are causing markets to reset in the short term, we see several countervailing positive factors that should benefit smaller companies, such as more attractive valuations, strong growth potential, re-shoring, deregulation, and diversification away from the high concentration risk in the large-cap indexes. Adding to all of this is the fact that, at the end of 2024, the Russell 2000 companies together represented only 4.7% of the Russell 3000 Index by market capitalization. You would have to go back to the late 1980s to see a similarly miniscule portion of the Russell 3000 being small caps—the long-term average is closer to 8%.

Small-Cap’s Weight in the Russell 3000 at Historical Low
The Russell 2000’s Total Market Cap as a Percentage of the Russell 3000’s Total Market Cap (%), 11/30/84-12/31/24

Source: FactSet.

At the same time, and following a two-year earnings recession and a better-than-expected earnings season, fourth quarter 2024 earnings seem to suggest that small-cap’s earnings may have bottomed and should lead the market over the next two years.

Average Expected Earnings Growth for 2025-2026
Index Aggregate Estimated Two-Year EPS Growth

Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The EPS Growth Estimates are the pre-calculated mean one-year EPS growth rate estimates by brokerage analysts. Estimates are the average of those provided by analysts working for brokerage firms who provide research coverage on each individual security as reported by FactSet. All non-equity securities, investment companies, companies without brokerage analyst coverage are excluded. Source: FactSet.

Given the increasing risk of an economic growth scare, whether from tariff tension, a slowing economy, or both, investors are rightfully focused on the potential for decelerating earnings and revenue growth. At the moment, it’s true that earnings expectations have fallen—but not significantly. Obviously, if the economic growth scare becomes a recession this dynamic will change. However, one of the best historical signals of a recession is so far not flashing—credit spreads remain very narrow compared to historical norms.

To be sure, corrections are never enjoyable. They are finite, however, and not all that uncommon. In fact, the average intra-year decline for the Russell 2000 going back to the end of 1999 through the end of 2024 is 20%—while the average annualized calendar year return over the same period was 9.2%. The equity markets hate uncertainty, and we continue to see plenty of headline and policy-driven risk in the near term that will drive market volatility. Yet it will also drive long-term opportunity, especially for an out-of-favor asset class that has been all but forgotten by many investors. Reversion to the mean is a powerful idea, as Ben Graham said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” We could not agree more!

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