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Could Small Caps Continue to Underperform Large Caps?

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1. Small Caps.

As I’ve discussed in the past, small caps have struggled this year despite optimism that a strong dollar would favor this style. The culprit: rising real rates, which tend to negatively impact small cap valuations more than those of large-cap firms. Historically, small-cap relative performance has been strongest when short-term rates–those controlled by the Fed–are falling. There is also a difference between a flat and rising rate environment. Since 1980 quarterly S&P 500 and Russell 2000 price returns have been roughly equal when rates are flat. In contrast, when rates are rising, large-cap stocks outperform roughly 65 percent of the time. As such, a delay by the Fed would suggest a more balanced environment for small cap and large cap returns.

Small Cap Continue to Underperform Large Caps

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Market Realist – Could small caps continue to underperform large caps?

Small caps (IWM) have underperformed large caps (OEF) year-to-date (or YTD), with the former falling 4.0% YTD while the latter has returned 0.9% YTD as of November 12. This is despite the fact that a stronger dollar (VTVT) hurts multi-national companies—which tend to be large caps—more than small caps, which are typically more domestically oriented.

The graph above compares the indexed performance of small caps relative to mega- and large-cap stocks (OEF) in different interest rate scenarios over the last 20 years. We used the yield on the ten-year Treasury (IEF) as a proxy for interest rates.

Large caps tend to outperform small caps in rising rate scenarios while small caps outperform large caps when interest rates are low or falling. The rationale for this is that when interest rates rise, the extra debt servicing costs squeezes small caps’ margins while large caps (IVV)(VOO) have enough in their coffers to navigate the high-interest-rate period. However, if the Fed delays the rate hike, small caps will get some breathing space.

Large caps tend to be mature companies, and their high-growth years are usually over. They usually acquire smaller companies to grow faster. Meanwhile, small-cap stocks are young and can potentially grow exponentially. So small caps tend to outperform large caps in the long term, as the graph above shows.

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