Large cap stocks have outperformed small caps since the pandemic, but smaller stocks have begun to close that gap in recent weeks. It’s still early, but if investors stay patient, we believe small caps could be poised to continue to outperform in the coming quarters.
This blog post explores what was behind small cap underperformance in prior months, and why smaller stocks may outperform going forward, particularly when we receive clearer indicators of an economic rebound.
In Initial Months of Pandemic, Mega Caps Enjoyed Mega Dominance
Large caps’ outperformance over small caps in the spring and summer was due largely to the very largest stocks in the indices, a trend we noted in prior blogs. Many of the largest companies by market cap are tech stocks, and their revenue streams were naturally resistant to the pandemic and a stay-at-home lifestyle. Individuals still need Microsoft to work from home, for example, and relied on Amazon for delivery more than ever before.
While those fundamentals supported mega-caps’ outperformance, retail investors catapulted the trend. Lower – and in many cases zero – trading commissions have encouraged more retail involvement in markets. Stay-at-home orders also played a likely role in encouraging more retail focus and participation in markets.
Greater participation from retail investors is not a bad thing. But smaller investors are more likely to follow household, mega-cap names and gravitate toward those stocks as a way to “recession-proof” their portfolios. They are less likely to participate in small cap investing, and this deepened the gulf in performance between large and small cap indices.
At a high level, we also weren’t surprised to see small caps underperform as the economic outlook deteriorated. Small caps are generally more sensitive to GDP growth and often underperform large caps when the market anticipates an economic slowdown. That trend tends to work in reverse when the market begins to rebound, which is part of the reason we believe investors should stay patient with their small cap allocations.
Is a small cap recovery on tap?
There are a couple reasons small caps may fare better in the coming quarters. First, relative valuations for small caps are compelling. Some relative valuation models that compare large and small caps (such as the one from Jefferies below) indicate that relative valuations for small caps haven’t been this attractive since 2003.
In the immediate near term, we would not be surprised if all stocks – small caps included – are buffeted by election-related volatility.
Once we get election results, however, we would expect the new Congress and president (regardless of party) to work quickly on a stimulus package. This could provide an immediate tailwind to small cap stocks, whose performance is generally more correlated to GDP growth than large caps. As we get a better handle on the coronavirus – either through a vaccine, better testing or other preventive measures – we believe small caps would be poised to continue outperforming large caps as the market begins to anticipate a market recovery.
How are we investing?
At Dana, we always take a sector neutral approach within our strategies, matching our sector weightings to our benchmark’s. This has left us invested in beaten down sectors such as energy and financials. Long term, we think our exposure in these areas will benefit performance once we see the early signs of economic improvement.
Any anticipated rebound in economic activity will likely boost oil prices, and this should in turn benefit the energy sector. We’re also starting to see acquisition interest in some smaller energy firms, which could put a floor on small-cap energy stocks. Financial stocks, meanwhile, have underperformed due to concerns about how low interest rates will hurt banks and some other financial companies’ earnings. But the sector typically rallies when there is a whiff of economic recovery.
In short, we aren’t predicting whether small cap stocks’ outperformance over large caps in recent weeks is the start of a changing of the guard just yet. But if we see any positive signs on the stimulus front, or with controlling coronavirus, small caps could be set up nicely. We believe investors should position themselves accordingly.