The Curious Case of Small Caps

Archive edition · Market data and company circumstances reflect 14 June 2024, when this newsletter was sent.

‘Sell in May and Go Away’ Failed Again!

May ended at all-time highs despite the fact that it tends to be among the weakest performing month of the year. Once more, the familiar saying “Sell in May and Go Away” proved unsuccessful. This strategy is commonly embraced by those who adhere to seasonal patterns, opting to sell in May and repurchase in October. Surprisingly, this timing-based approach has yielded impressive results on occasion, contributing to a reasonably favorable overall track record.

But there is one anomaly to this rule and that relates to S&P 500 making all-time highs in May. Every time May ends with all-time highs on the index, the rest of the year tends to generate positive return. Such instances have been observed five times in the last 10 years and S&P 500 closed the year with gains each time. Therefore, selling in May to return back in October can often time means buying at levels higher than the exit points.

Capital Concentration in Mega Caps

Unfortunately, this bull market just like the previous ones hasn't benefitted all the stocks uniformly. Once again, bulk of the buying is limited to mega caps, and such has been the trend in US markets for a very long time. All the highs made in S&P 500 & Nasdaq indexes can be entirely attributed to the mega tech stocks barring a few exceptionally well-run firms from a select few sectors.

*Market Capitalization (M-CAP) as of June 14, 2024

Overall, it's the Technology (XLK) and Communication (XLC) sector that has been at the forefront of every bull run with the mantle briefly handed over to other sectors such as Healthcare (XLV) during the pandemic and Energy (XLE) during early 2022 due to the beginning of Russia-Ukraine war leading to spike in energy prices.

Why Big Names Win Big

Here’s a list for some of the reasons why capital in-flows get concentrated into big names even during best of the bull markets:

Given the reasons enlisted above, it is highly unlikely that small and mid-cap group of companies will be able to outperform the index heavy weights in future even when as we gradually move towards the era of low interest rates.

Granted, there will be exceptions where a small cap doubles in a day or week due to corporate action, strong earnings and/or future guidelines or any other reason but actively finding them is akin to looking for needle in a haystack and foregoing the assured index returns in the pursuit.

• Index (ETF) Investing: Nasdaq and S&P 500 are market cap-weighted indexes i.e. the larger the company the more weightage it carries in the index and therefore, mega caps receive higher share of passively invested funds into their stocks.
• Big but Passive: Barring a few active hedge-fund managers, most deep pocketed investors prefer the comfort of mega caps that can safely emulate index returns instead of actively looking for undervalued stocks in mid or small cap space and take additional risk to generate outperformance. These investors generally belong to pension or sovereign funds category with low risk appetite as their primary goal is usually tied to capital preservation.
• TINA (There Is No Alternative) Effect: Because these stocks have performed well in the past and an average investor knows no better than investing in the commonly heard companies. For instance, most people still buy Apple as their first stock after opening their brokerage accounts. The new money tends to first flow into their stocks until the investor gets comfortable with risk taking and looks to diversify in other lesser-known names.
• Strong Fundamentals: Despite the overwhelming concentration of invested funds, there is no denying the fact that the mega caps are amongst the best run companies in the world boasting strong balance sheet, cash flows as well as expanding earnings per share for their investors. So naturally, they deserve to get the lion's share of every dollar poured into the US markets.

Underperformance of Small Caps in US

The ratio of the Russell 2000 small-cap index to the S&P 500 illustrates how far smaller companies lagged larger ones through June 2024.

Ratio Chart: RUT/SPX (Source: Tradingview)

Mathematically speaking, because this is a ratio chart of two mutually exclusive price series (RUT divided by SPX); in order to witness outperformance of RUT over SPX, we must see the graph moving upwards implying sustained outperformance for a long enough period to justify investing in small caps. However, as the purple arrow shows, the small cap index has been mostly underperforming the S&P 500 since 2013 and is showing no signs of revival at this stage.

Easier monetary policy could support a spell of small-cap outperformance, although a subsequent economic slowdown would test whether those gains endure.

Put simply, this graph is telling us that we must tamper down our expectations of a roaring bull market in small caps due to favorable US monetary policy.

Small-cap rallies had frequently lost momentum relative to large caps. Some Australian small caps also lagged while the ASX 200 traded near record highs.

Worst still, we ended up giving back gains in some counters after a decent run up because we stayed invested in the anticipation of achieving targets. Sometimes, the falls were so sharp that we had to cut loose the position in losses despite being in profits at one time.

Such volatile moves may seem like a paradise for short-term trader but for us investing with a longer-term view, it meant parking capital in an underperforming counter while we helplessly saw the index making new highs every other month.

How Does this Help You?

The underperformance of small caps leaves a very small room for error but if you are an experienced stock picker then it shouldn’t bother you much. However, when deciding between a large and a small cap stock to invest, the choice becomes obvious!

In the absence of passive ETF investors’ funds going into the small cap space, it is mainly the fundamentals and corporate events that drive the small stock higher. Even if small caps started to outperform, one cannot expect the momentary shoot up to last for a stretched period (24 months or more). This makes exit timings even more important that the entries.

The case for S&P 500 constituents rests on earnings visibility and the passive flows directed toward the index. Those advantages must still be weighed against valuation and concentration risk.

Archive note

This article preserves the analysis in our weekly newsletter sent 14 June 2024. Market prices, forecasts and company circumstances reflect the time of publication and may have changed.

This material is general information, not personal financial advice or a recommendation to trade. Investing and trading involve risk, including loss of capital.