A look back at history supports the idea of a shift in leadership to small-cap stocks.
How have large-caps and small-caps performed recently?
Something unusual has happened over the last year with regard to large-cap versus small-cap returns. Historically, they tend to move together, going up or down, though in different magnitudes. Over the last year, large-caps have advanced while small-caps have declined. To give you a sense of how unusual that is, over the past 20 years, it’s less than 7% of the time that we have had a trailing 12-month period with that kind of return divergence.
In Trailing 1-Year Periods from 6/30/99 to 6/30/19
Source: Bloomberg, as of 6/30/19. Small-Caps represented by the Russell 2000 Index and Large-Caps by the Russell 1000 Index. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
What do you think may happen next?
There are 14 periods where we have subsequent 12-month periods after this kind of large-cap/small-cap divergence. In 13 of those 14 periods, small-caps outperformed large-caps. It’s over 90% of the time, and the return differential was over 300 basis points. Now does that in any way guarantee that that’s going to happen over the next 12-months? It does not. However, it does suggest that the probabilities are pretty good for a leadership shift to small-cap stocks.
16 out of 229 Trailing 1-Year Periods from 6/30/99 to 6/30/19
Source: Bloomberg, as of 6/30/19. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
What would be the cause of this leadership shift?
There are two macro conditions that many investors may not be aware of, that have historically had an effect on small- versus large-cap performance. The first of those is economic cyclicality, measured more precisely by the ISM Manufacturing Index. So, in periods when the ISM Manufacturing Index is going down, it’s generally a better period for large-caps versus small-caps, and that’s what we’ve had since last year. However, when ISM Manufacturing Index is going up, small-caps have beaten large-caps over two-thirds of the time, and by several percentage points. So, if we are set for a reversal in that, it could also be good for small-caps.
Russell 2000 vs Russell 1000 Trailing Monthly Rolling 1-Year Returns From 6/30/99 through 6/30/19
Source: Bloomberg, as of 6/30/19. Note: The ISM Manufacturing Index rose in 111 of 229 periods. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The final indicator that historically has had an effect is the direction of interest rates, specifically 10-year yields. In periods like we’ve experienced when the 10-year yield is declining, that tends to be a headwind in small-caps versus large-cap returns. But at some point in the future, that’s going to reverse. And in periods when the 10-year yield has risen, small-caps have beaten large-caps over 70% of the time.
Russell 2000 vs Russell 1000 Trailing Monthly Rolling 1-Year Returns From 6/30/99 through 6/30/19
Source: Bloomberg, as of 6/30/19. Note: 10-Year Treasury Yields rose in 86 of 229 periods. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
So, taken together, we think there are a number of indicators which suggests the probabilities are pretty good for a shift in leadership to small-cap stocks.
Definitions:
A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction
The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
