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Historical analysis provides compelling insight into where small cap stocks are headed
John Riddle, our Chief Investment Officer, recently compiled Russell 2000 data to analyze historical market trends. The results indicate a possible inflection point for the small cap index.
Source: S&P Global; Jackson Creek Investment Advisors
The chart above plots the 2-year annualized returns on a rolling monthly basis for the Russell 2000. The negative 9.6% return as of June is the annualized two-year period from July 2021 to June 2023, where the absolute return was -18.3%. This analysis excludes dividends.
According to Riddle, “Out of 500 rolling 2-year periods, there have only been 28 where the Russell 2000 has produced a return equal to or worse than the value we measured for this past June.”
Since the Federal Reserve initiated its rate hiking schedule, the Russell 2000 has not kept pace with the larger stock S&P 500 and tech-heavy Nasdaq 100. The potential pain of a “hard landing” and negative effects of rising interest rates have been largely shouldered by the small cap index.
The silver lining here is that if the negative sentiment is already priced into small cap stocks, history shows us they typically respond quite favorably.
Furthering the analysis, Riddle also looked at subsequent 1-, 2-, and 3-year returns to the Russell 2000 during each of these periods. Of the 28 periods with trailing 2-year returns at or below the level reached in June, 27 of the following 12-months were positive. Additionally, in every instance the subsequent 2-year and 3-year returns were positive.
Source: S&P Global; Jackson Creek Investment Advisors
Even more promising is the magnitude of those returns. The average return in the twelve months following those 28 periods is 34.1%. That includes the single negative period in 2002, with a -23.2% forward 1-year return. The average 2-year annual forward return is 24.0% and the average 3-year annual forward return is 18.6%.
The scatterplot below shows the relationship between the trailing 2-year returns and following 12-month returns. The shaded area represents those past 1-year returns starting from points similar to where the index was in June.
Source: S&P Global; Jackson Creek Investment Advisors
So, what does this mean going forward? If past is prologue, the recent past bodes well for future small cap performance. We cannot predict with any accuracy what level the Russell 2000 will reach in the coming 1-, 2-, or 3-year periods. We can conclude, based on historical trends, there is reason to believe attractive returns in the Russell 2000 lie ahead.
Riddle concludes, “we are comforted by the evidence that future equity market returns may be more positive”.