article 11-02-2016

Is the Current Small-Cap Cycle Different Than Large-Cap's?

Co-CIO Francis Gannon explains why the different cycles for small-cap and large-cap stocks should matter to investors.

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Small-cap and large-cap stocks have different cycles, and this is important to any investor trying to figure out where equity prices may be heading.

We think the ultimate direction has a something to do with the respective age and dominant style of each asset class’s current cycle.

Looking back to when all stocks began to recover from the 2008-09 Financial Crisis, we have observed some very interesting developments and divergences in the cyclical patterns of small-cap and large-cap stocks.

Before going on, it's important to note that there is no standard definition of a market cycle. Each cycle must encompass both a bull and a bear market phase—going from a peak-to-trough through a trough-to-peak period. Views differ as to how large the decline and subsequent recovery need to be to constitute a full cycle.

At Royce, we define market cycles as periods that have declined at least 15% from a previous market peak and then rebounded to establish a new peak above the previous one. Each, of course, must comprise a peak-to-trough and trough-to-peak period.

Looking at cumulative returns for the small-cap Russell 2000 (the benchmark for most Royce portfolios) and the large-cap Russell 1000 Indexes reveals some compelling cyclical behavior over the last seven-plus years, starting from the post-crisis trough for both indexes on 3/9/09 through 9/30/16.

Small-Cap Bull Market Has Room to Run, Large-Cap Is Long in the Tooth
Russell 2000 vs Russell 1000 Cumulative Returns 3/9/09-9/30/16

R2K-R1K Cummulative

We think the following three observations are worth making:

  1. While both the small-cap and large-cap indexes have done well through this period, small-cap outperformed, advancing 304.8% versus 281.6%. (For additional context, the S&P 500 gained 276.3% for the same period.)
  2. As might be expected, small-cap achieved its performance edge with greater volatility, which can be gleaned from the chart and seen in the higher standard deviation for the Russell 2000 during the period, 18.07% versus 13.53% for the Russell 1000.
  3. Most important, the Russell 2000 has experienced two subsequent peak-to-trough moments—which can be seen in the chart—while its large-cap counterpart has yet to establish a new peak-to-trough experience since the March 2009 bottom.

Why do we think this is important? It suggests that comments about the extended bull market growing long in the tooth—and thus possibly primed for a major correction—are applicable primarily (if not exclusively) to large-cap stocks.

We've recently opined that both the bear (6/23/15-2/11/16) and bull markets (2/11/16-9/30/16) for small-caps are “stealth” markets in that they have received little comment beyond those who, like ourselves, are boutique specialists in the asset class.

From our perspective as small-cap specialists, we see a new and comparably quite young small-cap cycle that began with the previous small-cap peak on 6/23/15, one that also saw a significant leadership reversal in favor of value over growth.

To be sure, we have noted the risks of a possible correction. However, we also think that the current small-cap rally can continue through an intra-cycle downdraft—and that this new small-cap cycle, not yet 18 months old, will remain a value-led phase.

If history is any guide, that would mean good things for small-cap active management.

Stay tuned…

Important Disclosure Information

Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 1000 index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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