Just How Bullish Is Small Cap Strength?

“The strength in Small Cap stocks is wildly bullish. Stocks do much better when Small Caps are outperforming.” – Pundit

You’ve probably heard the above quote in various forms over the years. It’s a favorite among pundits and is never challenged.

We heard it again yesterday, with the Russell 2000 up 10 days in a row in one of its largest short-term advances in history. It is also trading at new all-time highs, a phrase that sparks an immediate emotional response.

But emotion is not evidence, and while we may want to believe that Small Cap outperformance means something particularly bullish, the only way to know for sure is to test it.

So that’s what I did and the findings may surprise you. Going back to 1978, when the Russell 2000 Small Cap Index is outperforming the large-cap S&P 500 Index, what tends to occur in the subsequent months?

If you guessed outperformance for the market going forward, you would be wrong.

In the forward 1-month through 12-month periods, both the Russell 2000 and the S&P 500 underperform in nearly all time periods.

The percentage of positive forward returns following periods of Small Cap outperformance is also lower than periods of Large Cap outperformance in nearly all time periods.

The historical evidence is clear. On average, stocks tend to do better following Large Cap outperformance, not Small Cap outperformance.

Why, then, do the pundits persist in saying the opposite?

Because their goal is to entertain you, not to educate you. If it sounds good to say that Small Cap strength is uniquely bullish, they will say it without hesitation. But enough about them.

Why is Small Cap outperformance not leading to above-average future returns? Good question. It’s not immediately intuitive as we have been trained to believe that Small Caps lead.

The evidence, though, suggests the opposite is true. Studies have shown that returns on large/liquid stocks tend to predict returns on smaller/illiquid stocks (see Lo and Mackinlay (1990); see Chordia and Swaminathan(2000)). When changing their position, large institutional investors tend to buy large and more liquid stocks first and then, over time, leg into smaller, more illiquid positions (see Lof and Suominen (2015)).

Is this always the case? No, there is no always in markets, only probabilities and averages. And those probabilities suggest that the recent Small Cap outperformance, while certainly not bearish, is actually less bullish than when Small Caps were underperforming earlier in the year.