Viewpoints
US small caps on pace for strong year-end finish

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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

      Boston - In November, the US small-cap Russell 2000 Index surged 18.4% — its largest monthly gain in the index's 42-year history. With this epic rise, the Russell 2000 was up more than 90% from its March bottom to set an all-time record; the last being in August 2018. So far in December, the small-cap index has tacked on another 9.4%, as investors are heartened by coronavirus vaccine distribution, despite spiking COVID losses.

      November's rapid rise seemed to stem from a rare combination of a focus on growth stocks alongside unbridled enthusiasm for a cyclical rebound — a trend that has continued. It wasn't just the small-cap space breaking new ground. The S&P 500 advanced about 11%, its largest November gain on record, and the Dow climbed 11.8%.

      Resolution to the US elections and encouraging Pfizer and Moderna vaccine news helped unleash a powerful pro-cyclical rotation by Russell 2000 value stocks early in November. By the end of the month, the outperformance of small-cap value relative to small-cap growth stood at just 1.7% for November as growth reasserted its leadership role. Value, however, is still lagging growth within the Russell 2000 by a massive 35 percentage points year-to-date.

      Market leadership rotations

      Since March, we've been positioning our portfolios toward value-oriented, high-quality cyclical stocks, but our results did not keep pace with November's dramatic moves. Our long-term focus of investing in high-quality, reasonably valued companies ran into the perfect storm in recent months, as small-cap market leadership has come from the extremes of deep value, cyclical stocks and high-growth companies.

      Looking at factor performance in the index really drives this home. In November, the five best-performing areas were penny stocks, unprofitable health care and technology companies, low share-price stocks, and pure value and high-beta stocks. On the other end of the spectrum, the five worst-performing areas in November were stocks with the characteristics of low-beta, strong dividend growth, stability, low volatility and quality.

      A focus on quality

      In our view, seeking higher-quality securities has been a consistent way to tap excess return over the long term. The small-cap opportunity set embodied in the Russell 2000 historically and consistently tilts toward low-quality characteristics. On the whole, margins, free cash flow and leverage remain poor for constituents of the Russell small-cap universe. Currently, valuations appear to be becoming stretched for both value and high-growth index stocks.

      Overall, we think quality stocks look very attractive on a historical basis and now, as ever, our focus is on high-quality, sound businesses that can deliver on fundamentals. In addition, we believe focusing on quality companies is critical in seeking to deliver favorable downside protection. Our long-term analysis, as well as our track record, indicate that although quality doesn't always deliver over the short term, it bears results over long-term, shifting market cycles.

      Bottom line: US small-cap stocks have set new records during the last months of 2020, led by an unlikely mix of both deep value and strong growth stocks. We continue to adhere to a disciplined application of our (Q)uality, (V)aluation, and (T)ime approach, which, although out of favor at times, has produced positive long-term results.