Small Caps, Large Caps… Any Difference?

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Small Caps, Large Caps… Any Difference?

To the letter of portfolio theory “law”, there are only two reasons to own a financial asset. The first is to generate a positive return. The second is that those returns are not entirely correlated with other positions in the portfolio. The former generates profits. The latter provides diversification and minimizes total risk.

Take as one example the Russell 2000 small cap index and the S&P 500. Since 1987, the former has compounded at 6.9% on a price basis, the latter at 7.4%. That checks the positive return box nicely, essentially a double on capital invested every 10 years.

But here are the trailing 200-day return correlations between the Russell and the S&P 500 over that time; the last 10 years occupies the rightmost quarter of the time series and as you can see the correlations have been quite high relative to history.

Thinking more broadly about what this chart says, we have 3 observations:

#1: There is a clear difference in correlations between 1988 – 1999 (average 0.75) and 2000 – present (average 0.89). This is significant, because it works out to an r-squared of 56% for the earlier period and 79% for the later one. On top of that:

  • Market swoons, which always push correlations higher, have had more impact on small caps since 2000.
  • The peak periods pre-2000 were 1989 (mini-crash caused by the failed UAL buyout), 1991 (Gulf War I), 1994 (surprise Fed rate hikes) and 1998 (Russian debt crisis/LTCM). In no case, however, did Russell-S&P 200-day correlations go over 0.85 for more than a hot second.
  • After 2000, average correlations (that 0.89 mentioned above) are actually higher than pre-2000 peaks. That plateau top you see in the chart at +0.95 occurred in 2011 during the aftermath of the Financial Crisis. Low points in correlations (2015 and 2018, during small cap rallies) had trouble breaking 0.85 correlations, the old pre-2000 highs.

Takeaway: having followed our share of small cap names in the 1990s we can remember when they were really a breed apart, but the correlation data clearly shows that is no longer as much the case.

#2: The logical follow-on question is “why have correlations tightened?”; here are two thoughts:

  • Regulation and technology have made the pricing of small cap stocks more efficient over time.

    Reg FD, which mandates even-handed disclosure of non-public information, came into effect in August 2000. Prior to that, managements could selectively disclose important information, and this took time to filter into stock prices (and especially so with less-followed small caps).

    Since the late 1990s, US stock trading has increasingly been executed on various tech-enabled trading platforms. At first these just ensured a stable price across various trading systems, but now they also incorporate fundamental information as well.
  • Monetary policy has had an increasing impact on stock prices since the late 1990s. As we noted in Markets, the “Fed Drift” shows substantially all the S&P 500’s returns from 1994 to 2011 were around FOMC meeting days.

Takeaway: the tightening of correlations between US small and large cap stocks has been going on long enough that we can safely call it structural rather than transitory. We’re not likely going back to a world where small caps were fundamentally decoupled from large caps.

#3: All this narrows down the reasons to own US small caps here:

  • It is no longer for diversification. Even the best-case scenario here only takes the r-squared to 72% (correlation of 0.85).
  • Rather, it is upside from small cap’s leverage to an improving US economy and lower high yield bond spreads. On the former, consider:

    The Russell is 15.4% Industrials vs. 8.3% in the S&P 500 …
    15.5% in Financials vs. 9.9% …
    13.6% in Consumer Discretionary vs. 11.4% …
    And, of course, there’s no Big Tech “work from home” stocks in the 2000.
  • As for the point about high yield spreads, which we talk about frequently, today we will look at actual effective yields on HY bonds. As the following 1-year chart shows, these are slowly moving down to pre-Crisis levels at 5.56% today versus a January low of 5.06%. As these rates continue to decline with further economic improvement, small cap stocks (often highly levered and minimally profitable) should see a tail wind.

Takeaway: we still like small caps, even if their greater correlation to large caps means they must sing for their supper on the merits of their future returns rather than their pre-2000 ability to diversify a portfolio.