With the Russell 2000 up double digits year-to-date (+10.0 pct) after a double-digit total return of 23.7 pct last year, what are the odds we can get yet another +10 point return in 2021? While this may seem like an overly simplistic question, it’s not. Markets discount the future with ferocious efficiency, so it’s actually unusual to see a 3-peat of +10 percent returns because it’s really hard to surprise markets three years in a row.
Case in point: We did this same analysis with the S&P 500 last month and it shows a third consecutive year of double-digit returns is quite rare. Here’s a quick refresh on that data before we move on to the Russell:
- The S&P has registered two consecutive years or more of annual double-digit total returns 19 times since 1958 (first full year of data).
- In the year after those 19 instances, the S&P was positive a little over half the time (58 pct) and up +3.6 pct on average on a total return basis. The best return was +33.1 pct in 1997 and the worst was -14.3 pct in 1973.
- The S&P only went on to produce a positive double-digit return for a third year in a row or more during 3 periods:
1963-1965: 1963 (+22.6 pct), 1964 (+16.4 pct), 1965 (+12.4 pct)
1995-1999: 1995 (+37.2 pct), 1996 (+22.7 pct), 1997 (+33.1 pct), 1998 (+28.3 pct), 1999 (+20.9 pct)
2012-2014: 2012 (+15.9 pct), 2013 (+32.1 pct), 2014 (+13.5 pct)
Our three main takeaways from this data for the S&P:
- History shows that a third year of double-digit returns is unusual and typically comes amid easing financial conditions and improving earnings such as during the bull run of the 1990s or after the Financial Crisis.
- Three or more straight years of double-digit returns are more common only recently, with longer economic cycles. Two straight years of double-digit returns tend to be sporadically sprinkled throughout a cycle.
- While it would not be unprecedented for the S&P to register a third year of consecutive double-digit returns in 2021, it is important to manage expectations as performance is typically more muted after this sequence of events.
As for the Russell 2000, here’s its history to consider:
- The Russell has posted two straight years or more of annual double-digit price returns 9 times since 1988 (first full year of comparable data).
- In the year after those 9 instances, the Russell was negative a little over half the time (56 pct) and down 0.15 pct on average on a price basis. The best return was +20.5 pct in 1997 and the worst was -21.5 pct in 1990.
- The Russell only went on to produce a positive double-digit return for a third year in a row twice:
1991-1993: 1991 (+43.7 pct), 1992 (+16.4 pct), 1993 (+17.0 pct)
1995-1997: 1995 (+26.2 pct), 1996 (+14.8 pct), 1997 (+20.5 pct)
Our three main takeaways from this data:
#1: Two straight years of double-digit returns for the Russell are common throughout a cycle, but a third straight year of said performance is rare as it requires a significant upside surprise from a catalyst that markets have not fully discounted. After two consecutive years of double-digit returns, the Russell’s average subsequent annual return is -0.15 pct, but history shows it’s essentially a coin toss as to whether it will be positive or negative.
#2: Small caps usually outperform when high yield spreads fall because a lot of the small cap index is unprofitable and needs access to reasonably priced risk capital. For example, high yield spreads over Treasuries were as low as 2.6 percentage points in September 1997, after the two periods when the Russell had 3 annual consecutive double-digit gains (1991-1993 and 1995-1997). That was the lowest level other than 2.5 points in May 2007 in a time series dating back to December 1996.
By way of another example, a rapid drop in high yield spreads after the Financial Crisis is a major reason why small caps had such impressive back-to-back returns in 2009 (+25.2 pct) and 2010 (+25.3 pct), even outperforming large caps. High yield spreads fell from a high of 19.9 pct in November 2008 all the way to 5.4 pct by December 2010. Here is the chart:
#3: Further gains in small caps will come down to high yield spreads continuing to narrow due to a robust 2021 US economic recovery and strong cash flows at highly levered companies. High yield spreads are currently at 4.3 percentage points, and they will need to get back to at least 2014 levels of 3.5 points to keep rallying next year. The good news is that’s attainable; they were as low as 3.3 pct in 2018 and 2.5 pct in 2007.
One final point: part of the reason small caps had such strong double-digit returns last year was due to a deep selloff in Q4 2018. As much as a rally in small caps into year-end 2020 would be welcomed, it’s hard not to wonder if it is pulling forward gains from 2021, making another double-digit return year even more challenging to attain. We will continue to watch the chart of high yield spreads as our best indicator of future small cap performance.