What Small-Cap Underperformance Tells Us

In small-stock underperformance, history tells us there's not much to worry about.

In small-stock underperformance, history tells us there's not much to worry about.

Consistent with the reputation of September and October as months that often see higher volatility, the onset of fall ushered in renewed financial-market turbulence.

Amid the pickup in volatility, much has been noted about the relatively wide performance difference between large-cap and small-cap stocks. For example, the Russell 1000 Index of large-cap stocks was up 6.5 percent year-to-date as of Oct. 2, while the Russell 2000 Index of small-cap stocks was down 4.8 percent for the period—a performance difference of 11.3 percentage points.

Similarly, the S&P 500 Index of large-cap stocks was up 6.9 percent while the S&P SmallCap 600 Index was down 4.2 percent—with a similar performance difference—11.1 percentage points.

This can be seen through the ETF lens by looking at the performance chart for the SPDR S&P 500 (SPY | A-97) and the iShares Russell 2000 (IWN | A-76):

Chart courtesy of StockCharts.com

This volatility has arisen despite continued signs of economic strengthening and solid corporate earnings. Economic growth stumbled early in the year, but it has strengthened as the year progressed. GDP increased at an annual rate of 4.6 percent in the second quarter, according to the Bureau of Economic Analysis. At the same time, unemployment has continued to decline, falling to 5.9 percent in September.

So what can we make of this performance gap between large-cap and small-cap stocks? How unusual is it and should it be raising red flags for investors?

While every expansion and market cycle is somewhat different, historical market behavior can shed some light on whether this recent performance gap is truly unique and cause for potential concern or perhaps not as uncommon as might be assumed.

Small-Caps Pausing

First, it's important to recognize that 2013 was an exceptionally strong year for U.S. equities. With total returns of 38.8 percent for the Russell 2000 and 33.1 percent for the Russell 1000, the year was the strongest since 2003, when both indexes also posted returns of about 30 percent or more.

Volatility was also far below longer-term averages in 2013, resulting in exceptionally strong risk-adjusted returns. The strong advances also led to higher valuations for both indexes, particularly for small-cap stocks.

Given the robust performance in 2013 and exceptionally low volatility, it's not surprising that leadership shifted to large-cap stocks in 2014 and that volatility has moved up moderately during the year.

Performance Gaps Of At Least 10 Percentage Points Not Uncommon

But small-cap stocks are not only lagging, they're posting negative returns. The large-cap and small-cap indexes are actually moving in different directions, and the return difference between the two is relatively wide. So how uncommon are these trends, and what could they be suggesting?

In examining the 35-year history of the Russell 1000 and Russell 2000 from 1979-2013, we can see that an annual performance difference of at least 10 percentage points between large-cap and small-cap stocks is not uncommon at all. In fact, over the 35-year history of the indexes, they have had an annual return difference of at least 10 percentage points in 12 years, or about a third of the time. The cap tier that has led has been relatively even, with large-caps ahead in seven years and small-caps in five.

Small And Large Have At Times Diverged Historically

While less common than meaningful return differences alone, the Russell 1000 and Russell 2000 have also moved in opposite directions at times over their history. This occurred during eight of the past 35 years, or nearly one-fourth of the time. The range of return differences during those eight years varied from 2.2 percentage points in 1994 to 29.5 percentage points in 1998.

When the indexes have moved in opposite directions, small-caps have typically been the asset class with the negative returns—six out of the eight occurrences. However, in two years (1981 and 2001), large-caps posted negative returns while small-caps posted positive returns.

A Look At The Historical Record

So what does this all mean? Does the fact that small-caps have declined while large-caps have advanced in 2014 indicate a potential market top or looming economic contraction?

A closer look at the six years in which small-caps have posted negative returns while large-caps moved higher can provide some insight into what followed historically after similar performance gaps. (For a complete data table, please see the paper "The Russell 2000 Index: Small cap opportunities in a slow-growth economic environment" on the Russell Indexes website at www.russell.com/indexes.)

• 1984: This was a year in which the return difference was 12 percentage points, with small-caps down 7.3 percent and large-caps up 4.7 percent. Annual GDP growth was 7.2 percent for the year. In the following year, GDP growth continued at a rate of 4.1 percent, and both the Russell 2000 and Russell 2000 advanced more than 30 percent for the year.
• 1987: This was also a year in which the return difference was about 12 percentage points, with small-caps down 8.8 percent and large-caps up 2.9 percent. GDP growth was 3.2 percent. A significant market correction did occur in October 1987; however, a recession was not on the horizon and GDP growth accelerated to 4.1 percent in 1988. Markets also recovered and were strongly positive in 1988, with the Russell 2000 advancing 24.9 percent and the Russell 1000 rising 17.2 percent.
• 1994: This was a year of weak equity market returns, with the Russell 2000 down 1.8 percent and the Russell 1000 up just 0.4 percent. However, GDP growth was strong at 4.1 percent. In the subsequent year, GDP growth remained solid at 2.5 percent, and the Russell 2000 advanced 28.4 percent, while the Russell 1000 rose 37.8 percent.
• 1998: As previously noted, this year marked the widest return difference in the indexes' history, as the Russell 2000 declined 2.5 percent and the Russell 1000 rose 27.0 percent in a market led by large-cap growth during the tech bubble. GDP growth was strong at 4.4 percent. In 1999, GDP growth remained strong at 4.8 percent and both indexes advanced about 21 percent. While an economic contraction occurred in 2001, it was still more than two years away.
• 2007: This was the only year out of the six in which a recession followed. The return difference for the year was 7.3 percentage points, with the Russell 2000 losing 1.6 percent and the Russell 1000 rising 5.8 percent. GDP growth was 1.9 percent for 2007, but then contracted in 2008 and 2009. Market returns were also negative in 2008, with the Russell 2000 losing 33.8 percent and the Russell 1000 falling 37.6 percent.
• 2011: The return difference this year was 5.7 percentage points, with the Russell 2000 declining 4.2 percent and the Russell 1000 advancing 1.5 percent. GDP growth was moderate at 1.8 percent as the tepid economic recovery continued to move in fits and starts. However, the following year saw signs of strengthening, with GDP growth of 2.2 percent and returns of about 16.4 percent for both of the indexes.

Bottom Line

Volatility has crept back into the market in 2014 amid heightened scrutiny of market valuations and questions about the potential timing of Fed interest-rate increases. After exceptionally strong returns in 2013 for small-cap stocks in particular, leadership has shifted to large-caps, while small-caps have posted negative returns so far for the year.

This move in opposite directions for the large-cap and small-cap indexes, along with a relatively wide performance difference, has led to questions about whether the markets are potentially poised for significant turbulence.

While meaningful corrections in the equity markets could occur at any time, the historical record shows that these types of return differences are not particularly uncommon and have not been predictive of either market tops or impending economic contractions.

In fact, in most years following those in which small-cap stocks have declined while large-cap stocks advanced, economic growth has remained solid or even accelerated, and market returns have remained positive.

David A. Koenig is an investment strategist with Russell Investments. For a list of relevant disclosures, please click here.