By Haik Aram Kevorkian
U.S. small caps have had their worst start to a year ever through September.
The Russell 2000 Index declined 2.2% in the third quarter, ending September 30, 2022, but outperformed large caps—which fell 4.9% as measured by the S&P 500 Index—by 270 basis points (bps), ending a five-quarter underperformance streak, the Russell’s longest since the six quarters ending 1Q99. As of September 30, 2022, however, the small-cap index is down 25.1% and underperforming large-caps by 123 bps. This decline represents its worst performance over this calendar period on record, slightly “surpassing” its 2002 start by a single basis point. Historically, the fourth quarter following negative performance through the first three quarters has tended to be strong, up 9.7% on average and rising 83% of the time. Similarly, the next calendar year has also tended to be strong, up 21% on average and also rising 83% of the time. If the fourth quarter is also down, the next year has tended to be higher.
This has been a particularly volatile year. The Russell 2000 Index has fallen on over half the year’s trading days, making 2022 (as of September 30) the second worst first-nine-months period on record by this measure, with only 1984 registering a larger percentage of down days. Happily, forward-year returns were all strong, averaging 33%, following the only other years when more than half the Index’s trading days were down. Over a third of this year’s trading days experienced declines of more than 1%. Looking back, only 2008 saw a higher percentage. Meanwhile, only 2009 and 2020 had a higher percentage of trading days that saw gains of 1% or more. Altogether, this means that we saw only 2008 had greater volatility, putting 2022 in rarified company.
The valuation on the Russell 2000 Index (last 12 months price/earnings (P/E), excluding loss-making companies) is at a 22% discount to its median historical level and only 8% above its March 2020 COVID low. Small-cap relative P/E has only been less expensive in June 2021, May 2021 and September 2020. Based upon relative P/E alone, we haven’t seen any other time in Index history that it has been as attractive relative to large caps as in recent times. Small-cap companies also reportedly expect an attractive earnings outlook next year, which could further favor relative valuation.
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