It’s no secret what happens when investors flick the “risk off” switch: As the relative safety of more stable companies gains favor, large-cap stocks typically open up a performance advantage over small-caps. So far, that relationship has held true in the market downturn of the past two months: the Russell 2000 Index has slid 10.58% since Sept. 14, lagging both the S&P 500 (-7.52%) and the S&P MidCap Index (-7.51%) by a wide margin.
This performance relationship may be a normal result of investors’ efforts to de-risk their portfolios, but that doesn’t mean it’s entirely justified. Consider that three of the four broad drivers of market performance are tilted more heavily against large-cap stocks right now:
- Global recession: While the recession in Europe became official on Thursday, the region’s negative growth was hardly a surprise to market-watchers. With the European economy hitting the skids and China still vulnerable to a further slowdown, heavy international exposure has been a negative for large-cap companies such as McDonald’s (NYSE:MCD), Coca-Cola (NYSE:KO) and IBM (NYSE:IBM). In contrast, small-cap stocks have much less exposure to the fortunes of the overseas economies — which could prove to be an important attribute in 2013.
- Changes to tax laws: A likely hike in the tax on dividend income has a much larger impact on large-caps, where the income stream is a more important element of the valuation equation than it is for smaller companies. In addition, any effort by investors to book profits ahead of a tax increase naturally falls more heavily on large-cap stocks given their larger representation in typical portfolios.
- The Apple effect: While Apple’s (NASDAQ:AAPL) rally made a huge contribution to large-caps’ outperformance through the first nine months of the year, the stock’s current collapse is now having a disproportionately negative impact. At its peak, Apple made up approximately 5% of the S&P 500 Index, so its subsequent 24% downturn has knocked a full 1.2 percentage points off the S&P 500’s return since mid-September. Take this out of the equation, and large-caps’ recent performance advantage begins to look even larger.
The fourth macro driver of current market performance is, of course, the fiscal cliff. On this front, small-caps’ domestic focus puts them at a disadvantage since the fiscal cliff is a uniquely American problem. If the U.S. economy does indeed tip into a recession next year, as many are expecting, small-caps would suffer accordingly.
On balance, however, small-caps are beginning to look interesting from a trading standpoint. The asset class not only boasts less headline risk than large-caps, but it also is suffering from extremely oversold conditions. The Russell 2000 is currently trading with a relative strength index (RSI) in the 20s, and it closed below its lower Bollinger band on Wednesday. This is a potentially compelling setup given that we’re about to enter the December-January period that typically favors smaller companies.
Longer-term investors also shouldn’t take their eyes off the ball when it comes to small-cap stocks. Looking back over the past 10 years, the 48.98% cumulative gain for the S&P 500 has been dwarfed by the 100.35% return of the Russell 2000. For all of the attention lavished on large-cap, dividend-paying stocks in recent years, the small-cap space has been the true engine of investor returns.
The Bottom Line
Right now, the outlook appears bleak. But once the pendulum inevitably begins to swing back in favor of risk assets, investors should strongly consider the iShares Russell 2000 Index Fund (NYSE:IWM) as a likely source of outperformance.