For those of us that run asset allocation strategies, being in the right place at the right time is, obviously, everything. Indeed, a foundation of risk parity strategies is that asset class performance stays within historical bands. Divergences from historical patterns causes problems. And that’s where we are today: in the middle of a big divergence between small caps and large caps.
Since its inception in the late 70’s, the Russell 2000 has generally outperformed the S&P 500. Although the Russell 2000 and S&P 500® usually exhibit a high correlation, they can have periods of massive outperformance/underperformance relative to one another.
Counterintuitively, small caps have typically outperformed large caps during periods of economic turbulence (1979-83, 1990-94 and 1999-2014); large caps typically outperform in the later stages of bull markets and during the strong phases of economic expansion. Most importantly, the outperformance during these periods by one versus the other is often gigantic.
The following data comes from an excellent article in 2017 published by the CME. I will crib from it liberally. https://www.cmegroup.com/education/featured-reports/equities-comparing-russell-2000-vs-sandp-500.html.
From 1979-1983 the Russell 2000 outperformed the S&P 500® by 80%. This was period of extreme economic turbulence. Double-digit inflation, double-digit interest rates and back-to-back recessions. Then, investors judged smaller companies better able to navigate than larger ones. During the 1990-91 recession, small caps outperformed the S&P 500® by nearly 50%. Most recently, from 1999-2014, a new era of turbulence (tech wreck, 9/11, Afghanistan and Iraq wars, subprime bubble, economic meltdown and quantitative easing), small caps outperformed large caps once again, this time by 114%.
During the long economic expansion of the Reagan years, the S&P 500® outperformed the Russell 2000 by 91%, more than recovering its 1979-83 period of underperformance. From 1994-1999, the strongest phase of the 1990s expansion, the S&P 500® outperformed the Russell 2000 by 93%.
Why are we bringing this up? Because the historic relationship has broken down. From the election in 2016 through the third quarter of 2018, with a relaxed regulatory environment, tax cuts, and a strong economic outlook – in other words, the perfect environment for large caps – small caps outperformed. Now, after one year of trade fears being front and center, yield curve inversions threatening recession, other classic late-cycle signs emerging – in other words, the perfect environment for small caps – small caps have materially underperformed large.
A reason perhaps is the makeup of S&P leadership has changed dramatically over the past five years. Dare we say it? It is different this time.
First, many of the companies now responsible for the S&P’s outperformance in this period of high stress did not exist during the last era of turmoil - Google and Facebook are just recently public, Visa only slightly older. Further, the rapid growth in passive investing, and Apple’s and Amazon’s dominance in passive investing, have had a significant impact on how markets behave.
This is not a FANG endorsement or argument. But large-cap tech names, as they have grown in stature and relative importance in index activity, have become safe havens of sorts. A hallmark of large-cap tech earnings has been their resilience in the face of cycles. The free cash flow generating capabilities of many of these names have been largely responsible for their market dominance – there is a reason why so many want to own them. Indeed, we have written previously on how today’s market dominance by large cap tech is well-deserved.
Much of this breakdown in the historic relationship of small cap versus large is also most likely influenced by the divergence between value and growth over the past ten years, which has been significant. For the past five years, the QQQ has outperformed the S&P 500 by more than 30%, and from 9/1/2008 (incorporating the GFC), the QQQ’s have almost doubled the performance of the S&P 500. With tech names now dominating the S&P 500 (MSFT, AAPL, AMZN, FB, GOOG, V all in the top 10 holdings. . . this shouldn’t be surprising. The S&P 500 isn’t the value index it once was.