Looking for a Small Cap Rally in 2020? Now Is the Time to Prepare

"Do the work now.”

So suggests Brandon M. Nelson, Senior Portfolio Manager of Calamos Timpani Small Cap Growth Fund (CTSIX), to financial advisors anticipating small caps to overcome 2019’s headwinds and start on a tear higher.

What Happened in 2019

High growth, high expectation stocks are subject to ebbs and flows, Nelson notes—with the most recent ebb starting in July 2019. The CTSIX team compares this period to the 2014-2015 correction which, as in 2019, was sparked by a dramatic rotation into deep value stocks at the expense of growth stocks.

When that happens, Nelson says, “the only way to win is to cheat, and we don’t do that. We're style-pure, we don't drift. There are different shades of what we do, but we stay in our stylebox and we won't drift. Because of that, when there’s a vicious rotation against growth, it can be a difficult period.”

The chart below compares the relative performance of the fund in 2014-2015 with the 2019 correction. In 2014, the fund took six months to establish the left side of the U, followed by a basing process (the bottom of the U), which was then followed by a strong performance surge (the right side of the U).

“Every downtick and uptick has their own sort of unique characteristics. This one has been more fierce than normal, no doubt, and who knows what that means,” says Nelson.

“I don’t know the amount of time we’ll be in the bottom of the U, the steepness of the drop or the steepness of the recovery. I don't know if today's the bottom or if today is the ideal entry point, but I've seen this movie before, and I've seen it many times. I believe there’s a pattern that will play out. I’m confident,” he says.

Small Cap Vs. Large Cap Performance

Nelson shares some additional observations about small caps in general and small cap growth in particular.

Since 1979, small caps have delivered what Nelson calls “lopsided” results—“In any given year,” he says, "the Russell 2000 tends to be up a lot or down a little.” While there have been five out of 41 years when the Russell 2000 generated a negative 10% or worse return, there have been 24 years when Russell stocks produced 10% or better.

And here’s what the distribution looks like when comparing the relative performance of large caps (S&P 500) to small (Russell 2000). Small caps outperformed 24 of 41 years, or 59% of the time.

Current Small Cap Vs. Large Cap Performance

The chart below shows what Nelson has been saying for months—that small caps are inexpensive relative to large caps. They’re in the range of 0.8 to 0.9, or 1.5 to 2.5 standard deviations below the midpoint.

Next look at the table that shows what has historically happened when small caps have been at 1.5 to 2.5 points below the midpoint in the range. As you can see, going forward from that point, small caps have outperformed large caps 83% of the time, and by a magnitude of eight percentage points or 800 basis points.

And here’s a look at the 300-day performance of small cap growth versus large cap growth. Again, small cap growth is so stretched to the downside that Nelson suggests investors could be approaching a “historic opportunity.”

Taken together, today’s factors look like an irresistible set-up to Nelson.

“We look for the asset class, now stretched to the downside, to mean-revert higher. CTSIX, also stretched to the downside, has historically mean-reverted higher,” he says. “Are there any ballplayers out there? We believe what we’re looking at right now is a fat pitch, an opportunity that could be worth swinging at.”

Financial advisors, if you’re doing the work now in anticipation of a small cap rally, talk to your Calamos Investment Consultant about CTSIX’s process for identifying companies with high, sustainable growth potential. Call 888-571-2567 or caminfo@calamos.com.

Click here to view CTSIX's standardized performance.