Small Caps Are Not All Gloom and Doom - If You Know Where to Look

The disruptions of the coronavirus pandemic have hurt small-caps stocks, badly, having fallen more than large-cap stocks. This is not surprising since in the early stages of previous bear markets, small-cap earnings also suffered more on average than their larger siblings.

In the wake of low returns and high volatility, investors may feel compelled to avoid this market. But history suggests they could pay a harsh price if they do. Now is the time to take a hard look at small caps: when assets deliver returns at the low end of the historical range, opportunity may be knocking.

We see great opportunities for active managers to identify differentiating factors and position their portfolios to emphasize the likely winners among small cap stocks.

Over the past three years, through the end of April 2020, small-cap stocks posted a modestly negative average annualized return of -0.8%. Negative returns are very rare, occurring in only 49 of 449 (about 10%) of all month-end periods since the Russell 2000 Index’s inception in 1978.

Investors might react adversely to negative returns, yet history suggests exactly the opposite. Performance following three-year negative return periods instead has been unusually strong:

Average Returns Following Negative Russell 2000 3-Year Return Periods vs. Long-Term Averages, from 12/31/78 through 4/30/20. Past performance is no guarantee of future results.

But investors’ risk aversion understandably rises during market storms. Volatility (the VIX) is a useful measure of the intensity of these storms. For April 2020, the daily VIX averaged 41.5% – a remarkably high level, in the highest 10% of all months since the VIX’s inception in 1989.

Following periods of high volatility, small caps often produce high returns: from 1Q 1990 through 3Q 2020, the average one-year return was 28.5%, and the average annualized three-year return was 17.4%. Small caps also tend to bounce back higher after highly volatile periods, beating large caps in 70% of subsequent one-year periods, and 81% of three-year periods.