Why Small Cap Stocks Are Lagging So Much These Days

Small Cap Stocks

Over the last year, the S&P 500 has gained 9.4%, while the S&P Small Cap 600 has lost 8.4%. We might be in a bull market, but these small stocks aren’t getting much love.

Whenever we see a stock, a group of them, or a stock index underperform, people will wonder why. If you don’t know enough about why stocks go up and down in the first place, then this exercise can be a pretty difficult one.

People who get confused here are the ones that use fundamental models to look to explain price action with stocks and indexes. In broad terms, there are some correlations here between fundamentals and price, and if we undergo a recession for instance or a boom period than people do act upon data like this to alter the course of stock prices, but this is just one of many factors and you cannot just take part of the story and look to tell the whole story.

What happens when you do that is your part of the story will often vary with what actually happens, and the small cap index lagging behind the large cap index by this much over the last year is a good example of this. If your model is limited to these fundamental data, and it doesn’t explain certain phenomena, you are left with just scratching your head.

A lot of people assume that there is some magic fundamental hand that guides stock prices, and it’s not even made the least bit transparent how this might work if it did exist. We just assume that stock prices are guided by these things, there is no attempt to look at other things, there is no proof to justify the assumptions of the model, it’s just a matter of having the belief and then sticking to it no matter what happens.

When we look at the macro fundamental data over the last year, we end up seeing that small caps should be benefiting more, and should be outperforming their much bigger cousins, large cap stocks. Among the evidence for this is things like small caps benefiting more from low interest rates which they benefit from more and their considerably lesser exposure to what trouble we have had lately, particularly the impact of the tariffs erected during the ongoing trade war with China.

Everything else being equal, something that this model just assumes, small caps should be outperforming large caps over the last year. Instead, we see large caps up nicely, with the S&P up 9.4%, and small caps well in the negative over the last year, with the S&P 600 Small Cap index down 8.4%.

If Fundamentals Don’t Explain It, Something Else Must Be Going On

Todd Rosenbluth, the head of fund research at CFRA, finds it “surprising to see how much small caps have underperformed large caps this year. There are a lot of things that should have made an environment that is favorable for small caps, but they haven’t been helping.”

This performance gap, 17.8%, is the largest that we’ve had since 1999. If you are looking for monsters under the bed, we might even want to suggest that this may portend some dark times for the market, because we know what happened the next year, the so-called dot com crash that saw stocks take a big dive, and a few people have even gone down this road.

It isn’t even rational to blame this on this performance gap though, and we certainly can’t take one random instance and look to conclude anything, and even if we had enough data, we’d still need to tie the two events together. The main reason why such a conclusion wouldn’t be valid is that this would involve pulling data from markets very removed from today, and stock markets in the ticker tape era is fundamentally very different from today’s markets.

This does bring up another assumption that people make, which is that small caps are more volatile than larger caps, so when we get a bull market, for instance we should see small caps well outperform large caps. We’re not seeing this over the last year, or over the virtually straight up 2019, or for that matter, over the last 10 years.

It is not that small caps haven’t done well since the bottom in February 2009, and the S&P 600 Small Cap Index has grown about 6-fold since then. The big index, the S&P 500, is up about 7-fold over this time, so the little guys haven’t won this battle and have lagged behind, and this is a significant time period that we’re looking at here.

We still hear that, “historically,” small caps are seen to outperform large caps in bull markets, and while that may be true, this really hasn’t been the case during what we could term relevant history, and any time we go back a long ways this ends up referencing times that are just too removed from today.

What has changed this landscape can best be explained in just four words, large cap index funds. When we are in a bull market, the side that gets the most money put into it wins, and large cap index funds, particularly those that track the S&P 500, have over the years gone from a minor player in the game to a massive one.

We Need to Follow the Money

When people invest in a major index fund, they don’t sit at home calculating how macro fundamentals stack up with, say, a small cap index, and base their decisions upon that, nor does this even factor into it. Most investors may have heard of small cap funds but that’s as far as their knowledge extends. Those who sell funds to them are also going to be promoting large caps a lot more, and if anything, add small caps for the purposes of diversification only.

It’s not just the little guys who invest in large cap index funds, as a lot of institutions do so as well. The gold standard for stock market returns is actually the S&P 500, which we even call “the market” now, and you don’t want to risk underperforming it because a lot of fingers will get pointed and this can get you in trouble or cause some real regret. No one blames you for playing “the market” regardless of how the market does because it then becomes the market’s fault and not yours as this is the benchmark.

In this competitive battle, between large and small caps, fundamentals don’t play much of a role at all. They do influence markets in general, as if the economy is doing well this will promote more investor confidence and also provide investors with more money to put in the market, but where they put it is another story, and these decisions aren’t really influenced by this data so much.

We also know, or should know, that the price of stocks is moved by other things, with investor confidence playing a big role. This investor confidence relies to some degree on fundamentals but far from exclusively, and just about anything can affect it, including the sheer weight of momentum.

If you see prices dropping, this in itself can reduce confidence and cause people to get out of the market out of fear, and there are times where this fear is very well warranted. The same thing happens on the upside, where climbing prices can inspire people to invest more and also hang on to their positions longer.

People just aren’t as confident about small caps generally, nor should they be, but this does create a self-fulfilling effect, where this lesser confidence can have small cap players bailing more.

When we look at the last year, this big difference in performance between small and large caps has been primarily caused by the much bigger hole that small caps dug themselves during the bearish final quarter of 2018. Large caps gave back 20%, but small caps sunk by about 30% during their bear move.

It is not hard to explain this though, as people are just less confident about these small companies than they are about the bigger ones, and when panic sets in, this lesser degree of confidence will really come home to roost. Small caps are actually up pretty nicely in 2019, not as much as big caps are but a 14% gain in a half of a year isn’t anything to sneeze at.

Big caps are up 20% year to date now, and while a 6% better return in 6 months is still very significant, the other 11.8% occurred last year, during the dog days of 2018, where small caps proved to be riskier on the downside and this gap remains and we’ve added to it in 2019.

When you have an asset that doesn’t go up as much but goes down more, this is not something that would be all that appealing to say the least. It should not be a surprise to us that small caps have underperformed, and although the gap may be a historically larger one, history does change and it is moving away from small caps more and more as they become pushed more and more to the periphery.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.