Though economic recovery may take a while, small-cap market appears to be full steam ahead

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      By Mike McLean, CFA Co-Director of US Small Cap Equity, Eaton Vance Management and J. Griffith Noble, CFACo-Director of US Small Cap Equity, Eaton Vance Management

      Boston - Eaton Vance and its affiliates seek to actively capitalize on opportunities presented by volatile investor sentiment, while ensuring that the portfolio risk profile remains appropriate for the specific strategy. The following are excerpts from a recent conversation with Michael D. McLean, CFA, and J. Griffith Noble, CFA, Co-Directors of US Small Cap Equity for Eaton Vance Management.

      What we are seeing: The remarkable rebound in US small caps continues, with the Russell 2000 Index as of June 10 up 55% from its March 18 bottom, and the large-cap S&P 500 Index up 45%. In a year of extremes, those gains represent the best three-month recovery for small caps since 1945. Year-to-date, the S&P is up 1% and the Nasdaq, up 11%, is at a new high. There is renewed equity market strength following the dramatically better-than-expected June 5 jobs report citing gains rather than losses. We've heard a number of people say this jobs report was the most surprising piece of economic data of their careers. While the employment gains are an impressive turn, the level of market optimism is still surprising given the jobless rate remains over 13%, its highest level in 80 years.

      In looking at the small-cap universe, we've commented a few times that tech stock valuations were starting to resemble levels at the peak of the tech bubble. Recently, however, we've seen small-cap value stocks take the baton for market leadership — rising about 14% over the last week and besting small-cap growth by about eight percentage points. Market recovery appears to be full steam ahead, with cyclicals and banks now mainly driving the rebound in small caps. Low-quality stocks continue to lead high quality, with the lowest-rated quintile (as measured by return on equity) ahead of the benchmark Russell 2000 by 1,600 basis points.

      We still believe that broader economic recovery will take a while, but markets appear mostly short-term focused. The massive amount of money flooding the system by central banks and lawmakers is definitely helping global economies and markets. Dropping $2 trillion on a $20 trillion economy can help solve a lot of problems. However, a number of factors — including consumer stimulus payments and shifting spending patterns in lockdown — make it hard to assess the true underlying run rates of businesses.

      What we are doing: For some time, we saw attractive opportunities in the value segment of the small-cap market. We had started to tilt our portfolios in that direction, but have seen many of the small-cap value stocks we purchased move up 40% to 70% in short order. Now we are looking for more fairly valued securities, but it's getting more difficult to find attractive names, especially with our bias toward quality. We are finding ideas in the auto and aerospace industries, select consumer businesses and cyclical industrials, while trimming in health care and technology.

      What we are watching: We are focusing on a number of areas in the market, including risks. We are watching what the rate of economic activity or unemployment may be once government stimulus checks cycle through the system. We have been keeping an eye on corporate leverage, bankruptcy filings and whether lawmakers consider any follow-on economic programs — and if that makes sense. The US election is only about five months away now and will undoubtedly affect markets. Lastly, we are watching the coronavirus. There were 19,000 new cases reported on June 8 alone, so the full impacts of reopening and mass protests on infection rates remain to be seen, along with government responses should an uptick occur.

      The team remains focused on analyzing company fundamentals, emphasizing longer-term earnings power and competitive positioning rather than backward-looking reported earnings. We continue to emphasize quality holdings and understanding how industries may be impacted over time in a changed era.

      Final word: Markets are now clearly pricing in a V-shaped recovery, and we see a number of small-cap stocks at all-time highs. In this environment, we believe it's more important than ever to focus on high-quality, sound businesses that can deliver on fundamentals. We believe it's also essential to employ strategies that seek to protect capital should these rallies prove premature and there's any stumble on the path toward economic recovery. Again, we believe our emphasis on downside protection and disciplined application of (Q)uality, (V)aluation, and (T)ime should position us for strong relative performance throughout shifting market environments and cycles.