Sizing Up the Candidates

The first half of 2024 was one of those periods that look fairly placid when judged by the returns for the major stock indexes—yet the first six months had their share of volatility—as well as a short-lived leadership shift in favor of small-cap. Extending the discussion to include July and early August shows even more interesting news—which we discuss in more detail below. For now, we’ll stick to the market events of the year’s first six months and look at each asset class’s candidacy for longer-term outperformance.

The year began with small-caps riding a strong fourth quarter of 2023 on both an absolute and relative basis. In fact, from the most recent small-cap low on 10/27/23—when large-cap indexes were also scuffling—through 3/31/24, the small-cap Russell 2000 Index advanced 30.7% and the large-cap Russell 1000 Index gained 28.9%. (Moreover, from that low through 2023’s small-cap high on 12/27/23, the small-cap index rose a heady 26.6% versus 17.2% for the Russell 1000. The Russell Microcap Index was also quite strong, rising 30.8% over this 61-day span, while the mega-cap Russell Top 50 Index “eked out” a 14.8% advance.) Yet sustaining this lead proved too tall a task for small- and micro-cap stocks—and our hopes for a more lasting leadership shift were dashed. Large- and mega-cap companies soon recaptured market leadership while small- and micro-caps struggled on both an absolute and relative basis. The upshot was that for the year-to-date period ended 6/30/24, the Russell Microcap Index was down -0.8%, and the Russell 2000 gained 1.7%—while the Russell 1000 was up 14.2%, the mega-cap Russell Top 50 Index advanced 22.1%, and the Nasdaq Composite rose 18.6% for the same period.

Bigger Was (Still) Better in 2024’s First Half
Returns for Russell Indexes, 12/31/23-6/30/24

Past performance is no guarantee of future results.

Needless to say, the last decade-plus has been a difficult period for most small-cap investors. Over the last 10 calendar years, the Russell 2000 outperformed the Russell 1000 only once—in 2016. The current extended period of small-cap underperformance is comparatively rare, though not without precedent. As we always do when looking farther back than the 12/31/78 inception date for the Russell 2000 and Russell 1000, we use the Center for Research in Security Prices 6-10 (“CRSP 6-10”) and CRSP 1-5 Indexes as our respective proxies for small- and large-cap stocks. Going back nearly a century to 12/31/31 through 6/30/24, we see eight market capitalization-based outperformance cycles, with the most recent period, which began in 2014, still in effect. The four small-cap cycles lasted longer on average, running 14, 11, 10, and 15 years, while large-cap cycles lasted 12, 5, and 16 years, with the current cycle running for just over 10.

Historically Small-Cap Cycles Have Averaged More Than a Decade
Average Monthly Relative Performance for CRSP 6-10 and CRSP 1-5, 12/31/31-6/30/24 (%)

Past performance is no guarantee of future results.

We think it’s also important to keep the events that have characterized the current cycle in context. After all, these mostly lengthy relative performance cycles do not occur in a vacuum. The current period encompasses the bulk of the zero interest rate, easy money epoch, the covid pandemic and its aftermath, and the fastest rate of increase in interest rates in U.S. history. In other words, the cycle has featured not one, not two, but three anomalous occurrences—along with a larger-than-usual dose of uncertainty that can most vividly be seen in the specter of recession that has loomed over the economy through much of the last three-plus years. To this already long list we could add the current period encompasses the bulk of the zero interest rate, easy money epoch, the covid pandemic and its aftermath, the constant thrum of expectations that the Fed would lower interest rates—which has been the insistent backbeat of the first several months of 2024.

The July Surprise—Is Small-Cap a Worthy Candidate?

Against this exceptionally atypical backdrop, we can now layer in the market’s results in July—which were so pronounced (to say nothing of being long overdue in our view) that market observers quickly christened it “The Great Rotation.” So, what created all of this attention? In July, the Russell 2000 advanced 10.2% and the Russell Microcap increased 11.9% versus a gain of 1.5% for the Russell 1000 and respective losses of -0.4% and -0.7% for the Russell Top 50 and Nasdaq. Additionally, the Russell 2000 Value Index finished July ahead of the Russell 2000 Growth Index, up 12.2% versus 8.2%. The Russell 2000's edge versus the Nasdaq was the fourth widest spread since the inception of the small-cap index after November 2000, December 2000 and February 2001. Relative to both the Russell 1000 and S&P 500, it was small-cap's third largest spread after January 1992 and February 2000.

The obvious question is, why are we seeing leadership shifts in favor of small-cap and to value (regardless of market cap size) happening now? The reason most frequently ventured has been the increased likelihood of a rate reduction in September. While we have no doubts that many small-cap stocks would receive a bump from lower rates, we also don’t see the likelihood of a September rate cut having been the catalyst (and in any case, we think that lower rates would likely fuel only a short-term spike). There is also the issue of timing. Fed Chair Jerome Powell alluded to a September rate cut as a strong possibility late in July—that is, after the nascent shifts were already well underway. Some have also pointed to the seemingly non-stop series of odd and unprecedented political events here in the U.S., though this, too, seems unconvincing. Markets dislike uncertainty more than almost anything else. From our perspective as experienced small-cap specialists and long-time market observers, it seems that the shift may be the product of one asset class—and style—giving way because investors began to recognize that there were other worthy candidates populating the investment landscape. The market is, after all, far more than a two-party system.

It is also important to keep in mind that we have seen the market equivalent of head fakes numerous times over the last several years—short-term swings in favor of small-cap that inspired optimism that was quashed almost as quickly as it had arisen. The end of 2023 offered just the most recent example. Additionally, small-cap is not yet out of the woods. Even after its brief and decisive outperformance, the Russell 2000 remained -4.0% shy of its previous peak on 11/8/21 at the end of July. Markets have been highly volatile of late, with the hellacious downturn in early August offering a sobering reminder of the speed with which market dynamics can reverse.

Canvassing the Precincts to Gauge Small-Cap’s Support

But recent volatility notwithstanding, we continue to see earnings acceleration as being the candidate most likely to ignite and sustain a small-cap leadership cycle, as we have been arguing for much of the last twelve months (though prior to July, the market admittedly kept insisting on disagreeing with us). Psychology and momentum can drive market returns over the short and even intermediate terms, but sooner or later, stocks tend to rise or fall based on an enterprise’s earnings. We think this is especially relevant now. At the end of June, the Russell 2000 had a near-record number of companies with no earnings, a total of 43.2%. At first glance, this may seem to run counter to our point. However, earnings acceleration is still expected to be higher for small-cap companies than for large-cap businesses through the end of 2024.

Small-Cap’s Estimated Earnings Growth is Expected to Be Higher in 2024 and 2025 Than Large-Cap’s
One-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 long-term EPS growth rate estimates by brokerage analysts. Long Term Growth (LTG) is the annual EPS growth that the company can sustain over the next 3 or 5 years. Both 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.

As active managers who focus on companies with steady earnings growth and/or high growth prospects, we are encouraged by this forecast, having identified many worthy candidates in our portfolios who appear poised to benefit from strong earnings, improved profitability, or earnings recovery. We think the case for our chosen asset class gains additional credence from the substantially more attractive valuations for small-caps compared to their larger peers, based on our preferred index valuation metric of EV/EBIT or enterprise value over earnings before interest & taxes.

Relative Valuations for Small-Caps vs. Large-Caps are Near Their Lowest in 25 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies), 6/30/99- 6/30/24

¹Earnings Before Interest and Taxes
Source: FactSet

We are admittedly biased in favor of our own candidate for market leadership but at the same time see the combination of cheaper relative valuations and better earnings as powerful arguments in favor of small-cap re-taking—and holding onto—market leadership in the coming months.

All Market Cycles Have Term Limits

To that end, we think it’s worth pointing out (as we often do) that all market cycles are finite. Neither the most bullish phases nor the most bearish downturns last forever. The same is true of flat markets or those more volatile periods in which investors can’t seem to make up their minds. Throughout the recent extended period of leadership for large- and mega-cap stocks, however, we recognize that it’s been easy to forget that market cycles have their kind of term limits. Indeed, we have been small-cap specialists with a long-term investment horizon for long enough to know that patience is a critical investment virtue—and that finding attractively valued opportunities during periods of relative underperformance creates the foundation for rewarding long-term results. So, while we have not been entirely happy with where the market has been over the last several years, we also understand that none of us gets an ideal set of market or economic conditions, at least not for very long. We thus always seek to make the best of the conditions we are given, secure in the knowledge that what we as a firm have been doing for the last 50-plus years should continue to stand us in good stead over full market cycles and other long-term spans. And even factoring in the formidable challenges of ongoing geopolitical and economic uncertainty, along with our own ideologically fraught politics, our conviction in the long-term prospects for small-cap investing remains strong and undiminished. In fact, our research shows that presidential election years have historically signaled good times for small-cap stocks.

Average Total Returns for the Russell 2000 and Russell 1000 After the Last 10 Presidential Elections
As of 6/30/24

Past performance is no guarantee of future results.

We understand that, while investment outcomes are perennially uncertain, the challenges we listed above are almost guaranteed to test the mettle, if not the blood pressure, of even the most sanguine and experienced investment hands. We also understand that more volatile markets lead many investors to press the ‘pause’ button as they await better days. With that said, there are two charts that sum up our thinking at this writing as to why waiting is seldom a sound strategy. The first shows how common deep intra-year declines have been over the last quarter century.

Russell 2000 Calendar-Returns and Intra-Calendar-Year Largest Declines
From 12/31/99-6/30/24 (%)

Past performance is no guarantee of future results.
¹Year-to-date data is not included in averages

The second shows what we might call the missed opportunities created by waiting too long to re-enter the market.

Average 12 Month Returns for the Russell 2000 During a Recovery Depending on Various Entry Points
From 10/5/79 through 6/30/24

Past performance is no guarantee of future results.

Against the backdrop of moderating inflation, normalized interest rates, and a still growing U.S. economy, we believe that, as the economy continues to stabilize, valuations for businesses that have lagged or largely sat out the mega-cap outperformance administration remain likeliest to rise. With no recession having materialized nearly three years after its imminent arrival being predicted, we see the probability of a soft landing for the resilient U.S. economy—which, we don’t hesitate to repeat, will begin to see more tangible benefits of reshoring, the CHIPS Act, and numerous infrastructure projects in the second half of 2024. Amid the difficulties of volatile markets and economic uncertainty (to say nothing of the incessant media noise that always accompanies election years), we think it’s crucial to remind investors of the opportunity to build their small-cap allocation at attractively low and/or reasonable prices—and we see these unsettled and at times unsettling days as an opportune time to invest in select small-caps for the long run.

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