Small caps smoked the S&P 500 last year and continue to outpace the broader market early in 2014. On a price basis, the Russell 2000 — a benchmark for small caps — is up 30% over the past 52 weeks, vs. a 25% gain for the S&P 500. For the year-to-date, the Russell is off 1.4%, while the broader market has lost 1.2%.
But that trend may not last — not after years and years of small caps leading the market. Market strategists see the S&P 500 gaining another 7% to 10% this year, which is fairly typical after such an unusually strong year like 2013. Historically, when the market has a red-hot run like it did last year, the following year serves up more muted gains. That doesn’t bode as well for small caps, which tend to outperform to the upside in more robust markets.
Additionally, activist investors are looking to take on some large-cap names, which would give that asset class an extra boost this year. However, even without that added drama, small caps have run ahead by so far for so long, they’re due to cool off relative to large-caps.
As Citigroup strategist Tobias Levkovich writes in a note to clients:
“Large caps should be able to generate better-than-average gains in the next 12 months. History is not always a perfect guide, but a variety of factors argue convincingly for large caps over their smaller cap counterparts after several years of small cap outperformance. It is even quite plausible that domestic mega-caps with very attractive valuation do well in 2014 as shareholder activists in the US have made size less of an issue with several extraordinarily large companies drawing attention in the past year alone.”
And make no mistake: Small caps have been clobbering the broader market for nearly five years now. As you can see in the chart below, since the bear-market bottom of March 2009, small-caps are up 237%, vs. a 171% gain for the S&P 500.
If nothing else, investors are likely to see a chart like this and figure that small caps have had their fun, making a change in leadership almost a self-fulfilling prophecy. Indeed, market leadership may have begun to change at the end of 2013. U.S. small-cap stock funds were the best-performing category in 2013, according to fund tracker Morningstar, which is no surprise. However, the small caps ended the year with a bit of a whimper, trailing the large-cap fund category by more than 2 percentage points.
Small Caps Hampered by Rates, Global Growth
If small caps do underperform vs. large caps, it will partly be due to a change in sentiment regarding everything from interest rates to global growth.
The Federal Reserve’s tapering of its bond-buying program has already led to an increase in longer-term rates. Small-caps, being more sensitive to debt markets than their larger peers, are more likely to feel the effects of costlier borrowing.
Additionally, after years of sluggishness to outright recession in Europe, investors are looking for a pick up in economic activity overseas. That makes large caps more attractive, given that a larger portion of their revenues are generated abroad. An analysis by Goldman Sachs figures that 34% of all S&P 500 revenue comes from international markets.
Over long periods of time, small caps do outperform large caps. Indeed, small-cap value is the best-performing asset class over long periods of time. So there’s no reason to dump your small cap and small-cap value holdings like the iShares Russell 2000 ETF (IWM) or the iShares Russell 2000 Value ETF (IWN).
However, if you’re looking to do some tactical rebalancing for 2014, you might want to overweight large-cap stocks and underweight small-cap stocks.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.