How Will Small-Cap Stocks Perform During And After This Recession?

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There’s fear in every corner of the market. This, however, is nothing new. Throughout history, economic recessions have led to an increased level of panic among market participants. However, it’s important to note that some of the best investment opportunities emerge during such trying times as well. Warren Buffett, arguably the most successful investor the world has ever seen, famously said:

“Be fearful when others are greedy and be greedy when others are fearful.”

Small-cap stocks, historically, have provided better returns in comparison to their large-cap peers in the United States.

Source: Federal Reserve

The above chart reveals another important characteristic of the performance of these two classes of securities. During recessions, which are marked in grey lines, the returns of small and large-cap stocks have converged. This usually happens because small-cap stock prices fall at a much faster pace than do large-caps when business activities decline significantly as a result of an economic downturn. However, immediately after a recession, small-cap stock returns have provided better returns than large-cap stocks.

The real question is whether a similar pattern can be expected this time around.

A recession is now certain

In mid-January, the Bloomberg recession prediction model read a 25% probability of an economic downturn this year. Investors, understandably, breathed a sigh of relief. However, things have turned on its head over the last couple of months, and the model now predicts that a recession is unavoidable within the next 12 months.

Source: Bloomberg

International Monetary Fund chief Kristalina Georgieva, in a statement released to the public on March 23, wrote:

“The outlook for global growth for 2020 is negative – a recession at least as bad as during the global financial crisis or worse. But we expect a recovery in 2021. To get there, it is paramount to prioritize containment and strengthen health systems – everywhere. The economic impact is and will be severe, but the faster the virus stops, the quicker and stronger the recovery will be.”

The recent convergence between small and large-cap stock returns also indicates that a recession is well and truly here.

How far will small-cap stocks fall?

Even though history might or might not repeat itself, the best way to answer this question is by evaluating the historical performance of small-cap stocks during bear markets. For ease of use, The Russell 2000 Index can be used as a proxy for small-cap stock returns.

Source: Royce Invest

The index, so far, has fallen about 28% from its recent highs. Going by empirical evidence, further losses can be expected in the coming months. Investors, however, should look at the long-term picture to determine whether betting on small-cap stocks at this juncture is the right decision.

It pays to stay invested

As of March 31, the 5-year annualized return for the Russell 2000 Index stood at -0.2%. All the reported gains were erased in a matter of a few weeks as COVID-19 wreak havoc. This is bad news to start with, but there’s reason to believe that a massive recovery is on the cards.

Whenever the index returned a negative performance in a 5-year period, the following few years have been spectacular.

Source: Royce Invest

While this is encouraging news for investors, conducting thorough due diligence is required before making investment decisions. Also, there’s a very real probability of history not repeating itself as things cannot be taken for granted when it comes to investing in equity markets.

Investors who are already long on equity securities of small companies might be finding it very difficult to stay invested because of the bloodbath in global capital markets. However, historical data reveals that divesting stocks now could turn out to be penny-wise, pound-foolish.

Takeaway: look at the big picture

Global equity markets will most likely continue their freefall in the next few weeks. Countries across the globe are implementing stay-at-home policies to curb the spread of the virus, which is not good news for the global economy. Reduced consumer spending, declining corporate profits, and negative sentiment toward economic growth will likely drive stock prices down. However, investors should not lose hope.

The pandemic-induced market crash will not be long-lived. China is a classic example of this. As the two-month-long lockdown came to an end in the latter half of March, business activities started gaining traction. The Wall Street Journal reported last week that mobility is finally reverting to its normalcy in some Chinese provinces. The United States and the Western world will likely follow this lead from China. Within the next couple of months, things will start returning to their normal state, boosting the investor sentiment toward risky assets such as equities.

According to economics theories, small-cap stocks will recover faster than billion-dollar companies from a recession because these companies will report much larger bumps in revenue and earnings than their large-cap peers. This naturally leads to attractive returns.

The best course of action is to accumulate shares of small companies or invest in exchange-traded funds that focus on these types of companies while prices are still cheap relative to their earnings expectations. This, certainly, can be classified as being greedy when others are fearful.

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