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Royce Funds Commentary: When Will Small-Caps Outperform Large-Cap Stocks?

How have large-caps and small-caps performed recently?



Something unusual has happened over the last year with regard to large-cap versus small-cap returns. Historically, they tend to move together, going up or down, though in different magnitudes. Over the last year, large-caps have advanced and small-caps have declined. To give you a sense of how unusual that is, over the past 20 years, it's less than 7% of the time that we have had a trailing 12 months with that kind of return divergence.

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Rare Occurrence: Large-Caps Rose and Small-Caps Fell

In Trailing 1-Year Periods from 6/30/99 to 6/30/19

rare-lc-rose-and-sc-fell-w

What do you think may happen next?



There are 14 periods where we have a following 12-month periods after this kind of large-cap/small-cap divergence. In 13 of those 14 periods, small-caps outperformed large-caps. It's over 90% of the time, and the return differential was over 300 basis points. Now does that in any way guarantee that that's going to happen over the next 12 months? It does not. However, it does suggest that the probabilities are pretty good for a leadership shift to small-caps.

What Happened After 12-Month Periods When Large-Caps Rose and Small-Caps Fell?

16 out of 229 Trailing 1-Year Periods from 6/30/99 to 6/30/19

when-lc-rose-and-sc-fell-w

What would be the cause of this leadership shift?



There are two macro conditions that many investors may not be aware of, have historically had an effect on small- versus large-cap performance. The first of those is economic cyclicality, measured more precisely by the ISM Manufacturing Index. So in periods when the ISM Manufacturing Index is going down, it's generally a better period for large-caps versus small-caps, and that's what we've had since last year. However, when ISM Manufacturing Index is going up, small-caps have beaten large-caps over two-thirds of the time, and by several percentage points. So if we are set for a reversal in that, it could also be good for small-caps.

When the ISM Manufacturing Index Rose, Small-Cap Outperformed Large-Cap

Russell 2000 vs Russell 1000 Trailing Monthly Rolling 1-Year Returns From 6/30/99 through 6/30/19

r2k-r1k-rising-ISM

The ISM Manufacturing Index rose in 111 of 229 periods.

The final indicator that historically has had an effect is the direction of interest rates, specifically 10-Year Yields. In periods like we've experienced when the 10-Year Yield is declining, that tends to be a headwind in small-caps versus large-cap returns. But at some point in the future, that's going to reverse. And in periods when the 10-Year Yield has risen, small-caps have beaten large-caps over 70% of the time.

When the 10-Year Treasury Yield was Rising, Small-Cap Outperformed Large-Cap

Russell 2000 vs Russell 1000 Trailing Monthly Rolling 1-Year Returns From 6/30/99 through 6/30/19

r2k-r1k-rising-rates

10-Year Treasury Yields rose in 86 of 229 periods.

So taken together, we think there are a number of indicators which suggests the probabilities are pretty good for a shift in leadership to small-caps.

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of July 10, 2019 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

The ISM Manufacturing Index (ISM) monitors employment, production, inventories, new orders and supplier deliveries.

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

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This article first appeared on GuruFocus.