Main Street and Wall Street Do Not Always Walk Hand in Hand
Co-CIO Francis Gannon shares his thoughts on the current (overdue) pullback and why discipline and selectivity are essential.
“We see this as the main lesson from the current overdue pullback, which seemed all the more inevitable after the strong start to 2018. The immediate trigger seems to have been better-than-expected employment and wage gains last week. In this case, good economic news led to bad market news. This counterintuitive relationship may continue.
Of course, other related factors may have also come into play. As is often the case, it was likely a confluence of events, ranging from rising inflationary expectations, higher bond yields, fears of an overheating economy, and overall investor complacency. After all, it has been more than 700 days since the last 10%+ correction in the Russell 2000 Index. Prior to the current sell-off, the largest small-cap decline had been 6.4%, which occurred in September 2017. The large-cap cycle is even older, dating back to the March 2009 low following the Financial Crisis.
It is always important to remember that stock market corrections come and go—they are as inevitable as they are unpleasant and, we believe, ultimately healthy in the context of this particular small-cap market cycle. Investing during painful declines can be one of the most effective ways to build strong absolute long-term performance. We do not know where or when we will reach the bottom of this correction. Every day, however, we seek to take advantage of its dislocations to build strong absolute long-term returns. In an environment characterized by higher volatility and lower returns, discipline and selectivity will be essential.
As small-cap specialists, we continue to believe that performance in the asset class will be driven by three factors: a preference for profitability, relatively lower valuations for both cyclicals and value stocks, and burgeoning economic strength at home and abroad. Being less yield sensitive, cyclicals potentially gain an additional advantage in a new era of rising rates.
Our outlook for small cap stocks remains mixed: we think the index will deliver lower returns over the next 3-5 years than it has more recently, while we also see great opportunities with selective small-cap stocks.”
Source: The Royce Funds Small Talk Blog (emphasis by Madison)