Over the past few months, small-cap stocks have significantly underperformed compared to large-cap stocks, notes Schaeffer’s Investment Research. The S&P 500 Index has remained around breakeven since the end of January, while the Russell 2000 Index has dropped just over 10%. This is the first time the Russell 2000 has fallen by double digits over a three-year period while the S&P 500 has remained positive since May 2000, just before the tech bubble burst, leading to a two-year bear market.
Schaeffer’s latest research explores how stocks have historically fared depending on the Russell 2000’s performance relative to the S&P 500.
Investors are clearly becoming more risk-averse as the three-month relative strength of the Russell 2000 compared to the S&P 500 shows that they are selling off dicey stocks in favor of steadier big-cap names. By studying data from 1990, Schaeffer’s discovered how the S&P 500 performed based on the three-month relative strength of the Russell 2000 to the S&P 500.
Small and mid-cap shares have been underperforming this year for two reasons. First, they have a larger share of financial service stocks than their larger peers, notes CME Group. Secondly, the failure of Signature Bank and SVB hit small banks and smaller tech firms much harder than it did big banks and large tech firms.
If small-cap underperformance indicates investors’ risk-averse nature, then it also serves as a superb contrarian indicator. The S&P 500 has shown the highest average returns when big caps outperform small caps over the prior three months.
When small caps underperform the big caps, the S&P 500 has had an average return of double-digits over the next year. When small caps have outperformed the most, the S&P 500 has averaged a 5.5% return over the next year. This trend also exists at shorter time frames, according to Schaeffer’s.
When small caps underperform over a three-month period, stocks in general tend to do well going forward. To prevent skewing the results with extreme market environments, Schaeffer’s analysis was limited to times when the S&P 500 was up or down no more than 2.5% over the previous three months. The data consistently shows that when small-cap stocks underperform big caps over a three-month period, the markets tend to do well going forward.
CME Group points to a consistent theme: small caps tend to outperform during periods of turbulence that feature volatile interest rates and inflation, and economic downturns as well as early-stage economic recoveries. Large caps have tended to outperform during the later stages of economic recovery.
Small caps’ historical record for outperforming during turbulent times comes down to three factors:
- Low debt levels: smaller firms typically can’t access credit or debt markets as easily as larger ones and so they tend to have lower leverage ratios, meaning they are less impacted by interest-rate volatility.
- Flexibility and focus: smaller firms tend to be nimbler and can respond faster to changing economic conditions. The flip side of this is that large firms tend to outperform during the later stages of economic expansions when being nimble counts for less.
- Exposure to international trade: smaller firms have less exposure, in general, to foreign markets and are thus typically less exposed to geopolitical events and global supply chain disruptions.
While the Russell 2000 has the longest time series, the S&P SmallCap 600 and S&P MidCap 400 follow nearly identical patterns as compared to the S&P 500’s performance. Investors whose portfolios are tied to these indexes have seen that the S&P small and mid-caps have tended to outperform the S&P 500 during turbulent economic times and underperform during the later stages of economic recovery.
