This website uses cookies to collect usage information in order to offer a better browsing experience. By browsing this site or by clicking on the "ACCEPT COOKIES" button you accept our Cookie Policy.

Small-Caps Are Gaining Traction as Light Appears At the End of the COVID Tunnel

After a long period of either underperformance or mixed relative returns, small-caps in the US are now finally gaining meaningful traction relative to large-caps.

As shown below, the relative return of the small-cap Russell 2000 index versus the large-cap Russell 1000 index has broken out of the range it has been in since June. The latest move started after the Pfizer vaccine news hit on November 9th, after making an initial move in early October.

US Small cap return

Our view has long been that small-cap relative performance follows a cyclical pattern, with the best return/risk payoffs coming when the economic and market cycle have been weak and are starting to recover. The early stages of a new expansion or bull market are thus typically the best for small-caps, while the later stages of an expansion or the early phases of a bear market or recession tend to be better for large-caps, especially after accounting for risk.

The current economic cycle has been very unusual. After a record-long expansion, a very rare external shock (a virus) hit, causing far higher amplitude in the economic data (record-setting declines and recoveries), along with historically huge policy interventions (fiscal and monetary stimulus, etc.). The heavy uncertainty about how the current cycle will play out may explain why small-cap relative performance has only recently started to show the upturn we would expect as conditions start to improve after a recession. The recent signs of progress on a vaccine (or multiple vaccines) offer the prospect of “getting back to normal” next year, and may reduce some of the headwinds facing smaller companies relative to larger firms.

Several other indicators suggest the small-cap outperformance trend may be a better bet now than earlier this year.

First, US small-caps are outperforming across all sectors over the last month, indicating a broad-based trend. This includes the Technology sector, where large-cap Tech had outperformed small-cap Tech by 30% for the year through September 1st, but since then small-cap Tech has outperformed its larger brethren by 12%.

Second, as shown below, the “volatility penalty” for owning small-caps has declined and is now back to relatively low levels. The rolling three-month volatility of the Russell 2000 index has now fallen back to just a small differential over the volatility of large-caps (Russell 1000). That is, investors do not have to take on substantially more risk (volatility) in their portfolios by choosing small-caps over large-caps, as they would have done earlier in the year.

us small cap

And third, small-caps outside the US have been outperforming for some time now (as shown in the lower two sections of the chart below), and therefore US small-caps may have some catching up to do.

global small cap

With price activity looking better and the cyclical backdrop potentially becoming more favorable, there could be more room for the recent trend of small-cap outperformance to run over the coming months.

Originally Posted on November 19, 2020 – Small-Caps Are Gaining Traction as Light Appears At the End of the COVID Tunnel

Disclosure: Mill Street Research

Source for data and statistics: Mill Street Research, FactSet, Bloomberg

This report is not intended to provide investment advice. This report does not constitute an offer or solicitation to buy or sell any securities discussed herein in any jurisdiction where such offer or solicitation would be prohibited. Past performance is not a guarantee of future results, and no representation or warranty, express or implied, is made regarding future performance of any security mentioned in this report.

All information, opinions and statistical data contained in this report were obtained or derived from public sources believed to be reliable, but Mill Street does not represent that any such information, opinion or statistical data is accurate or complete. All estimates, opinions and recommendations expressed herein constitute judgments as of the date of this report and are subject to change without notice.

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Mill Street Research and is being posted with permission from Mill Street Research. The views expressed in this material are solely those of the author and/or Mill Street Research and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

trading top