The appeal of small-cap stocks

Since March 2021, on a total return basis, small cap stocks have underperformed large cap stocks by almost 60%, according to Bloomberg. While surging prices for tech stocks (e.g., the Fab 7) go a long way to explaining why this has happened, it's also likely that tight monetary policy in recent years has also boosted large cap stocks at the expense of small caps. This case was bolstered by today's price action which followed Chairman Powell's speech in Jackson Hole, in which he indicated the Fed is getting ready to resume the easing of monetary policy that started two years ago but which has stalled since then.

Today was a good day for all stocks, but small cap stocks advanced 2.3% more than large cap stocks. So far this month, the total return on small cap stocks has exceeded the return on the S&P 500 by 4.7%. The following charts are telling us that this dynamic could have a lot more room to run.   

Chart #1

Chart #1 compares the level of the S&P 500, the most popular and well-regarded index of large cap stock prices, with the Russell 2000, the equivalent index for small-cap stocks. Over time, the chart shows that these two indices have experienced gains of similar magnitude, but there are times when they diverge. The two y-axis values are based on the fact that the S&P 500 index value tends to be about double that of the Russell 2000 index; or conversely, the Russell value tends to be about half that of the S&P 500. 

Background info: The Russell 2000 index contains the smallest 2000 stocks of the Russell 3000 index, and has a current market cap of about $3.1 trillion. The S&P 500 index, in contrast, has a market cap of about $55 trillion, and is composed of what could arguably be termed the 500 largest and most successful companies in the U.S. It's hard to imagine two indices with greater differences: big and successful vs. very small and obscure—David vs Goliath. Yet there are times when small caps outperform large caps, and we could be at the beginning of one of those times.

Chart #2

Chart #2 shows the ratio of the Russell 2000 index to the S&P 500 index. Small cap stocks have underperformed large caps by roughly 40% over the past 12 years, with the ratio declining from 0.64 to 0.36.  Over the period shown, the ratio has averaged 0.5, and it appears to be mean-reverting. Should the ratio revert to 0.5, that would imply a small-cap outperformance of roughly 35%.

Chart #3

Chart #3 compares the ratio of the small cap/S&P 500 indices to the level of the yield on 5-yr TIPS, which in turn is a decent proxy for how tight Fed monetary policy is (it's inverted to show that a rising red line equates to easier monetary policy, and a falling red line equates to tighter monetary policy). With the exception of a few periods, these two lines tend to track each other, thus reinforcing the thesis that monetary policy has an important influence on the relative behavior of small- and large-cap stocks. 

It is commonly thought that easy money is good for small cap stocks because small companies are generally more leveraged and thus more sensitive to changes in interest rates, whereas large companies are less leveraged and thus better able to weather adverse conditions, among other things.

What stands out of late is the divergence of the two lines which began about two years ago; monetary policy has been slowly easing (as seen in the rising red line) but the small cap ratio has been declining. Today's price action—in which small caps outperformed large caps by 2.3%—marks what could be an important turning point in favor of small caps—thus reestablishing historic patterns. Note that a similar (but opposite) divergence happened in the 2005-2008 period.

CPI and GDP update

We've been in Maui the past few weeks on our annual family vacation. The island is still recovering from the Lahaina fires 2 years ago (we were there at the time in happened), but there are finally visible signs of rebuilding. Nevertheless, labor is in short supply and prices at the supermarket are sky-high, and to make things worse the island is suffering from a highly unusual dearth of rain, such that the golf courses have been denied water and are slowly turning brown. We were there when the tsunami warning was issued, but it turned out to be a nothing-burger, at least in northwest Maui.

The charts that follow are updates to the CPI and GDP using data that were released in recent weeks.

Chart #1

Chart #2

Chart #1 shows the 6-mo. annualized rate of change in the CPI and the ex-shelter version of the CPI, while Chart #2 shows the year over year change of these two variables. Over the past six months, both measures of the CPI were at or below the Fed's target. I doubt you heard this news in the media, which is anxious to see inflation popping up everywhere thanks to Trump's tariffs. Over the past year, both measures were a tiny bit above the Fed's target. Is that a cause for concern? Hardly. As you can see from both charts, it is the nature of the beast for inflation to wobble above and below 2% on a month-to-month basis.

Chart #3

The thing to remember is that the source of the past several years' inflation is the enormous growth in the M2 money supply. This "extra" money has by now been largely absorbed, thanks to rising prices and tight monetary policy. This is illustrated in Chart #3. With little or no excess money in the economy, there is no reason for inflation to rise on a sustained basis.

Chart #4

Chart #4 shows the 1- and 3-mo. annualized rate of change of Owner's Equivalent Rent. This makes up about one-third of the CPI, and it has for the past two years been the sole reason that the CPI has been above target for the past two years. As I've explained many times, the way the BLS calculates the shelter component of inflation is highly questionable, and almost certainly based on data that is one and two years old—so that it is a very lagging indicator of the true cost of living. In any event, this measure of inflation has been trending down for almost 3 years, and is currently running at a 3.4% annualized rate. It's almost certain to fall further, given that we know that nationwide housing prices—and rents—have been flat to down for the past year and show no signs whatsoever of rising. As OER declines it will become clear to the unenlightened that inflation is behaving as it should.

Chart #4

Chart #4 shows the growth of real GDP over time, plotted on a log scale axis to better illustrate trend rates of growth. The green line is an extension of the trend that prevailed from the 1960s through 2007 (3.1%). The red line is the trend that has prevailed since mid-2009 (2.3%). Actual GDP tends to wobble a bit from its prevailing trend, but not by much. We're still in a 2% growth world, which is unremarkable. I doubt we'll see any significant improvement for awhile, given all the uncertainties surround Trump's tariffs and deportation policies. Eventually we should see some remarkable improvement, as Trump's attacks on taxes and regulatory burdens begin to reap benefits.

We must never lose sight of the enormous gap between where the economy is today and where it might have been if pre-2007 conditions had prevailed. I estimate the gap between the red and blue lines to be roughly $6.4 trillion. In other words, the economy—and incomes—might have been 27% bigger today if policies had been more sensible and less burdensome. Trump has made it clear he wants the economy to return to a 3% growth path, and for the most part his policies support that goal.

UPDATE (8/20/25): For an extended discussion on possible reasons GDP growth downshifted in the wake of the Great Recession (Chart #4), see this collection of my posts on the subject.

California Leavin'

California, with its fantastic climate, gorgeous geography and huge size, has been a mecca for millions ever since the Gold Rush. Perhaps life here has been too easy for many, and too rich for liberal politicians eager to redistribute the wealth. Democrats especially have found life to be easy, with the party having a virtual lock on state and local power centers. 

Government has become increasingly lazy and disfunctional; the roads are a mess, traffic is the bane of everyday existence, taxes and regulations are oppressive, and modest cottages start at $1 million. Famously, Los Angeles can't even keep the fire hydrants and reservoirs full. Not surprisingly, there is an ongoing exodus of state residents and many of its major corporations. The state has spent tens of billions of dollars on an absurd "bullet train" without managing to lay even one foot of track. Thank goodness Trump has put this project out of its misery. The scattered bridges and columns that have been completed should be left standing for future generations, as monuments to the stupidity and corruption of our politicians. 

As a 5th generation Californian, with ancestors dating back to the Gold Rush, it pains me to post these facts: Grok reports that "Between 2020 and 2025, approximately 500 companies have moved their headquarters out of California or shifted significant operations elsewhere, with a notable spike in relocations since 2019. From 2018 to 2021 alone, the Hoover Institution reported 352 companies relocating their headquarters out of the state."

Nuni Cademartori, my good friend and great artist, penned the above cartoon which I featured in a post almost five years ago. Back then it seemed like there was little hope for any change on the horizon.  

Sadly, things have just continued to get worse. The only thing that has changed are the names of the companies opting to move out of California, as this second cartoon illustrates. 

I especially like the signpost on the right: "Gavin Newsom Memorial Highway." Yes, Gavin Newsom deserves full credit for the deterioration of this great state. May this be a warning to the rest of the country. In case you haven't already noticed, our Guv thinks he would be an ideal choice to run the country after Trump. Heaven help us if he gets the chance!