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Why Did Small-Cap Stocks Have a Stellar Year in 2016?

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Small-cap stocks in 2016

Small-cap stocks have outperformed large caps on a regular basis since 1926. They delivered 11.4% versus 9.5% for the larger stocks on a CAGR (compound annual growth rate) basis. However, they aren’t always on investors’ bucket list because of a higher risk profile. The outperformance is due to a much higher growth scope for the small caps. Risks arise due to less financial cushion, relative to large caps, to overcome tough periods.

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Good year for stocks

2016 was a good year for stocks, even though it was slightly volatile. While small-cap stocks had a stellar year with the Russell 2000 Index (IWM) up 23% YTD (year-to-date), broader markets as tracked by the S&P 500 index (SPY) rose 15%. In this series, we’ll discuss what caused the outperformance and whether it will likely continue in 2017 and beyond.

Is a stronger dollar good for small caps?

The above graph compares the total annual returns on the Russell 2000 Index and the S&P 500 Index over the last ten years. While small caps have been underperforming large caps in 2014 and 2015, they had a stellar year in 2016. They outperformed the latter by ten percentage points on a total returns basis. Small-cap stocks also outperformed the large-cap stocks (OEF) since the Great Recession due to monetary accommodation.

Many suggested that the stronger dollar (UUP) has been the major reason behind small-cap stocks’ outperformance. The rationale is that a stronger dollar impacts the currency-adjusted profits of large-cap stocks. Large-cap stocks have high exposure to international markets, while small-cap stocks focus domestically.

While that’s true, small-cap stocks have historically had a negative correlation with the dollar. Also, the dollar’s rally in 2014 and the current rally came about due to higher interest rate expectations—a negative for small-cap stocks.

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