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.