The Small-caps Bellwether (With Video)

The video that accompanies this blog is here:

When new clients first come to our firm, we often find their portfolios packed with large-cap stocks, companies that are valued at more than $10 billion. These are the companies that comprise the S&P 500.  Although large-cap stock is a good place to start, once you begin to build a portfolio, it is essential to include small-cap stocks with $300 million to $2 billion in market cap. These companies are much smaller, so they have more significant potential to deliver outsized returns than larger companies. 

Small-cap stocks tend to have higher growth rates because it is easier to double and triple their revenue growth due to the lower starting point, but their profits are more vulnerable to recessions and other market shocks making them more volatile. They also accrue their earnings domestically, so they are less diversified than large-cap stocks. 

Small-cap stocks tend to outperform during the start of a bull market when the economy is recovering, and businesses are seeing solid earnings.  At this time, small-cap stocks rise even more quickly than large-cap. As a recession approaches, they sell off more extensive stocks, hit their bottom before the economy reaches its nadir, and lead the market out of the slump. For this reason, small caps can be considered a bellwether. 

For example, the Russell 2000, which tracks the performance of small-cap stocks, took off at the bottom of 2003 and outperformed the much larger S&P 500 in the ten years of 2000 to 2009 by a significant margin, as the chart below shows.

The Russell 2000 Index is the most widely used index of small-cap stocks.   The Russell 2000 is a market capitalization-weighted index, as are most popular stock indexes (the Dow Jones Industrial Average being the main exception). This means that the 2,000 companies that make up the index contribute differently to its performance. Larger companies have a proportionally more significant impact than smaller ones.  Still, it is a more diversified index than the S&P 500, which helps mitigate the risk.

The following ten years showed small-cap and large-cap to be correlated, but once the bear market hit in 2021, small-cap underperformed, demonstrating how volatile this asset class can be.  This can be seen in the chart below.

It is essential to understand the role of a small cap in your portfolio and why it makes sense to remain invested.  Timing the market and forecasting the recovery is nearly impossible, but we know that small caps tend to move first and quicker than large caps at the top and bottom of the market.  Interestingly, in the first two weeks of June, the Russell 2000 Index gained 6.9% compared to a 1.8% increase in the S&P, as shown in the chart below.  We experienced a surge like this in January of this year when the asset class was up 13.7%. Still, then continued rate hikes by the Fed renewed recession and debt ceiling fears, and the failures of Silicon Valley and Signature Banks resulted in a downturn. 

Small-cap stocks outperform over the long term, but their growth is far from a straight line.  This asset class has lived up to its reputation over the past couple of years, with 10% or more swings in either direction. It should be noted that we see the same dynamic internationally, although not as pronounced. While the price-to-earnings ratio is at all-time lows, the possibility of a severe recession makes the future uncertain.  For this reason, too much small cap in your portfolio could make even the aggressive investor a bit queasy.

We know that whether or not the economy continues to weaken, the downward trend will end, and when that happens, small caps will start moving up.  Further, this will happen before we realize the economy is in recovery—however, no need for concern since our client’s portfolios are already in position. Success is achieved by knowing why you hold the asset class and having the discipline to stick with it.  A little bit of patience and a strong stomach can also help.