US small-cap’s candidacy for market leadership

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

Source Russell Investments. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a 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 outperformance cycles lasted longer on average, running 14, 11, 10, and 15 years, while large-cap outperformance cycles lasted 12, 5, and 16 years, with the current outperformance cycle running for just over 10 years.

Historically Small-cap Outperformance Cycles Have Averaged More Than a Decade Compared with Large-cap Outperformance

Average Monthly Relative Performance for CRSP 6-10 and CRSP 1-5, 12/31/31-6/30/24 (%)

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

Source: FactSet. 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.

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 Last Twelve Months (LTM) EV/EBIT (ex. Negative EBIT Companies), 6/30/99- 6/30/24

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

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 (%)

Source Russell Investments. Year-to-date data is not included in averages. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

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

Source Russell Investments. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

Against the backdrop of moderating inflation, normalized interest rates, and a still growing US 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 US 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.