In “ordinary” times, large and small cap stocks have historically performed similarly
with a relatively high correlation of 0.89 out of 1.001. However, in times of severe
market swings, small caps tend to underperform based on the inherent risk associated
with investing in smaller corporations. This year has been anything but ordinary in the
stock market and has amplified a divergence in performance between large caps and
Year-to-date as of 6/19/20:
- Large cap stocks, represented by IVV, are down 3.2%
- Small cap stocks, represented by IWM, are down 14.4%
Looking back to early 2017 when small caps began underperforming large caps,
- Large cap stocks are up 47.8% from 1/1/17 to 6/19/20
- Small cap stocks are up 9.5% from 1/1/17 to 6/19/20
Performance of large and small cap stocks over a ten-year period can be seen in the
Furthermore, the large and small cap indexes are allocated differently to the 11 sectors which can cause dislocations and divergences in performance over time. For example, the Information Technology sector has outperformed the other sectors year-to-date and the large cap index has over 11% more weight in the IT sector than the small cap index. The small cap index has a greater allocation to economically sensitive sectors such as Financials, Industrials, and Real Estate, whereas the large cap index has a greater weight to Communication and Information Technology, which are economically sensitive but to a lesser degree. The chart below illustrates the 11 sector weightings for the large and small cap index.
Additionally, large cap stock’s revenue tends to have greater global diversification. The
pie chart2 below illustrates the large cap index revenue by region from 2018; large cap
stocks still receive a majority of their sales from the U.S. but is only 57% of the total mix2. On the other hand, small cap stocks receive roughly 77%3 of their sales from the U.S.
Lastly, as history suggests, small cap stocks tend to fall harder than large cap stocks in recession but they also benefit the most as the economy emerges from the downturn. As the US economy continues its reopening efforts, small cap valuations are attractive and may be well positioned to outperform large cap peers. At Gradient, we are actively examining this divergence and adjusting positioning to potentially benefit from a rebound in small cap stocks. This is currently most relevant in our ETF-Endowment Series portfolio. In closing, divergence between asset segments happen periodically, but it is important to assess the underlying causes for these changes and determine whether the divergence is structural or temporary.
1. Correlations between IWM and IVV from 6/2000 to 6/2020