This article first appeared in ETF Insider, to read the full edition, click here.
Investing orthodoxy teaches us that smaller companies tend to outperform over time. After a decade in the dark, however, will central bank rate cuts provide a backdrop for small cap ETFs to stage a comeback?
The so-called ‘small firm effect’ was examined in a book by Jeremy Seigel and Jeremy Schwartz titled Stocks for the Long Run. Between 1926 and 2021, they computed, small caps delivered annual returns of 11.99%, slightly ahead of large caps at 10.35%.
Perhaps the book’s most surprising finding, though, was that virtually all the small cap outperformance came during one golden nine-year window between 1975 and 1983.
For the rest of the period returns were all but neck-and-neck – but that is not to say they moved in perfect step.
As Chart 1 illustrates, small caps, as proxied by the Russell 2000, tend to outperform for a period of years, such as between 1998 and 2013, before large caps, as proxied by the S&P 500, take over the running. Market leadership is cyclical.
Chart 1: Russell 2000/S&P 500 data, 1978 to present
Source: LSEG, Shiller data, ETF Stream calculations. The chart uses price, rather total return, index values due to availability of data. A rising line illustrates small cap outperformance.
The current cycle, in force since 2013, has seen blue skies for large caps while small caps – in relative terms – have made heavy weather of it.
The clouds have been particularly dark since 2018. Around then, mega cap tech stocks – spearheaded by Apple, Amazon and more recently Nvidia – began to deliver stellar performance and increasingly dominate large cap indices. Small caps could not keep pace.
A ray of light came from the US inflation print in June this year, however. It showed inflation dropping faster than expected causing futures to price even faster and deeper interest rate cuts.
This precipitated an eyepopping rally in small cap indices. Companies of diminutive stature typically carry higher borrowing costs and thus benefit more from lower rates.
The rally posed an important question: was the dramatic small cap rotation a flash in the pan or a fundamental turning point in market leadership?
ETF Stream asked investors for their views on the fortunes of small caps over both a short and medium time horizon, as well as how they were playing this in portfolios.
The short-term: The next 12 months
Jaisal Pastakia, investment director at Handelsbanken Wealth & Asset Management, presented a bearish view for small caps over the coming year.
For him, two things are required for small caps to perform: easier monetary policy and improving growth prospects.
However, Pastakia contends monetary policy is unlikely to come to the support of small caps. “Our expectation for the next few months is that interest rates go from ‘restrictive’ to ‘less restrictive’, which is different to outright ‘easy’,” he said.
The growth backdrop does not favour small caps either. Large cap earnings are rising while small cap earnings, which tend to be more cyclical, are declining.
Pointing to the ISM Manufacturing New Orders, Pastakia noted that many forward-looking indicators augur ill for small cap earnings. As such, he has been underweight small caps and expects to remain so.
“We continue to favour large caps with a bias towards quality,” he added.
Stephan Kemper, chief investment strategist at BNP Paribas, on the other hand, believes that small caps have a “fair chance” of outperforming large caps over the next year.
With the Fed cutting in the context of a robust economy, small cap earnings are expected to pick up while the growth of large cap earnings appears to be slowing.
“This narrowing gap in profit makes the valuation premium of large caps vs small caps incredibly unsustainable,” he argued.
Within the small cap universe, he expressed a preference for “quality” – favouring the S&P 600 small cap index over the more cyclical Russell 2000.
For Iain Barnes, CIO at Netwealth and Dan Caps, investment manger at Evelyn Partners, the matter is more finely balanced and is likely, at least to some extent, to hinge on the outcome of the presidential election.
According to Caps, smaller companies certainly have significant potential to outperform under the right economic backdrop.
“Easing monetary policy and looser fiscal conditions combined with increasing consumer confidence and business investment” could be a boon for small caps, he said.
However, if there is an inflationary spike and tighter policy, or a more dramatic slowdown than currently predicted, smaller companies will continue to struggle – an assessment Barnes concurred with.
Both investors highlighted the significant small cap outperformance on the back of a Trump victory in 2016.
For Barnes, “the 2016 analogue suggests a strong initial bump for US smaller companies. However, it isn’t clear that corporate fundamentals are strong enough to convert this to a more long-standing advantage.”
Barnes sees more opportunity in UK small caps given improved recent market sentiment.
The longer view: The next 5-10 years
Looking further out, Caps is constructive on smaller firms.
“We would expect smaller companies to make up ground as we move through the early stages of an economic cycle,” he said.
As such, he established a “moderate” small cap position earlier in the year and will be watching US economic data very closely in the coming months before deciding whether to add.
Kemper is bullish on small caps over the medium-term, too.
"The starting point for small caps is much more appealing from a valuation perspective,” he asserted. “Based on the historic relationship between the P/E ratio and 10-year forward returns, the S&P 500 is expected to return somewhere between just 4-5% [in the next decade].”
At a high level, Kemper is a strong believer in the small firm effect. He considers “the current phase of large cap outperformance as some sort of a correction in a long-term trend.”
According to Barnes, however, the small firm effect has been “severely tested” in recent years.
He noted, as did Pastakia, that the outperformance of large caps has coincided with the growth of private markets which has encouraged companies to go public ever later in their development – with mixed results for investors.
On balance, Barnes concluded: “We believe traditional market cycles have been extended rather than broken, but we need to see a catalyst of better structural economic growth in support.”
Pastakia is less sure. For him, “changes in market structure challenge the validity of the small firm effect.”
Pastakia observed that small cap outperformance comes in “fits and starts” but does not believe now is an optimal time to move from his underweight. The best opportunities for small caps come in the depths of a recession when rates are rates are dropping, sentiment has collapsed and valuations are on side, he explained.
Unlike Kemper, Pastakia does not view current small cap valuations as attractive, with the S&P 600 trading above its long-term average P/E ratio.
“As recently as 12 months ago you could have argued that [small cap] valuations were supportive enough to provide attractive returns over a five-year time horizon; there is much less confidence in this statement now,” he concluded.
