Between 1975 and 1984, small caps delivered a powerful annualized return of 35% — more than double the 15% average gain of large caps. On a cumulative basis, that's a spectacular advance of 1,400% in less than a decade.
There have been plenty of academic inquiries over the years trying to find the root cause of this surge. Some point to the passage of the Employee Retirement Income Security Act (ERISA) in 1974, which, among other regulatory safeguards, encouraged more diversification in retirement plans.
Others conclude that having been burned by the implosion of the Nifty Fifty, savvy investors began paying more attention to valuation and risk-adjusted returns. There's nothing quite as impactful as a lesson learned the hard way.
Or maybe small caps were just overdue.
Well-respected studies by Dartmouth Professor Kenneth French show that smaller stocks have had a measurable edge over their larger siblings over the past century. But investor sentiment can favor one group over the other for extended periods of time.
Just like the Nifty Fifty era, large-cap stocks have held the upper-hand in recent years. The bigger the better. Market-crushing gains propelled the "Magnificent Seven" to a combined market capitalization of $16 trillion a few months ago, compared to just $3 trillion for the Russell 2000 Index.
In other words, these seven behemoths had more market weight than two thousand small caps put together. Five times more. This clique also traded at a rich P/E ratio above 50, twice that of the broader market.
A catchy nickname. Ubiquitous brands. Sky-high expectations. Narrow market breadth. Excessive valuations. Sound familiar?
Now, I'm not necessarily saying to avoid Nvidia (NSDQ: NVDA) and Apple (NSDQ: AAPL). However, Warren Buffet made the prescient call last year to unload more than 500 million shares of the latter (about half of Berkshire's stake).
Predictably, this overheated group has cooled off in recent months, rattled by the emergence of a new Chinese Artificial Intelligence platform that rivals western AI tools with shockingly cheap development and training costs. This breakthrough upends the notion that it takes astronomical spending to achieve results in this new frontier.
But that's a story for another day.
The Macro Stars Aligned
I'm more interested in a possible small-cap resurgence. It's not too hard to draw parallels to prior runs.
First, an extended period of relative underperformance where investor sentiment has been markedly biased in favor of larger companies, widening the valuation gap.
According to Morningstar (which uses its own proprietary indexing methodology), large caps have trounced small caps over the past year. The same is true over the past five years. And over the trailing 10-year period, the big boys have soundly whipped their smaller counterparts by an annualized score of 12.4% to 7.2%.
That's a difference of 500-plus basis points per year.
The last time small caps took the lead? You have to go back to 2016, when the Russell 2000 produced a strong return of 21.6%. If you'll recall, the U.K. Brexit vote ruffled a few feathers that year, which coupled with a slowing U.S. economy, forced investors to switch gears.
Sooner or later, money rotates.
We could be seeing the early signs of another divergence in favor of smaller stocks. Earlier this month, the Russell 2000 held its ground while the benchmark S&P 500 posted its sharpest weekly loss since October. You can probably guess the reason: tariffs.
Since smaller companies generate the bulk of their sales (almost 80%) inside the U.S., they are less vulnerable to import duties, trade wars and foreign currency headwinds. Of course, that's just a broad observation; there are exceptions. You wouldn't expect, say, a bank to have the same exposure as an airline.
We don't paint everything with the same brush.
Still, there is precedent for this market behavior. Back in March 2018, the U.S. government imposed $60 billion in tariffs on Chinese goods, which in turn provoked reprisals from Beijing. Over the next 90 days, the small and mid-cap segment of the market (as measured by the Russell 2500) doubled the return of the large-cap S&P 500.
Tariffs aren't the only wild card.
This group also stands to benefit from a trio of recent rate cuts, with several more expected over the next 6-12 months.
Lower rates are generally viewed as more beneficial to smaller businesses, which are often leveraged and lack the liquidity and credit lines of more established companies. If small caps were restrained by the highest borrowing costs in decades, then they have more to gain from normalizing rates.
Wainwright Investment did some research into this phenomenon. Here's what they found. Over the past four pre-COVID loosening cycles, the Russell 2000 was more responsive and went on to deliver an average gain of 10.8% over the next year, versus 8.2% for the S&P 500.
We could be on the cusp of that now, with economists anticipating further loosening on the horizon. Meanwhile, disinflation (and geopolitical uncertainty) could help strengthen the dollar, another important factor to weigh.
A weaker dollar tends to benefit large multinational companies. Not only does it stimulate export sales in foreign markets by making their products less expensive (and thus more competitive) in local currencies, but it also provides a currency translation tailwind/bump when all those euros and yen are converted back into greenbacks.
So it follows that a stronger dollar does the opposite, turning those tailwinds into headwinds… and thus favoring smaller companies that are more attuned to the U.S. economy.
We can put a number to this as well. Perritt Capital Management found that in periods when the dollar gains 15% against a basket of foreign currencies, the Russell 2000 outruns the S&P 500 by 13.2% to 10.3% annually.
Finally, as with previous market dislocations, the flood of investor capital being poured into large caps has inflated valuations — leaving many small caps trading at a pronounced discount. I think we've seen this before.
There's an old axiom that history doesn't repeat itself, but it does often rhyme. So while today's Magnificent Seven may not befall the same fate as the Nifty Fifty, it's easy to see why research outlets such as Morningstar see another "Reversal of Fortune" for smaller stocks.
Continued unwinding of the AI mania that whipped up the mega-cap froth could be just such a catalyst.
That's why I've been steering readers towards Royce Small-Cap Trust (NYSE: RVT). The boutique asset management shop is a pioneer in this space and devotes nearly all its analytical heft to this one asset class. Launched in 1986, this was the first closed-end fund dedicated strictly to the small-cap universe.
With a focus on undervalued businesses that produce high returns on invested capital (RoIC), RVT has outperformed the benchmark Russell 2000 Index over the trailing one-, three-, five-, 10-, 15-, 20-, and 30-year periods. Over that time frame, the fund would have turned a $10,000 investment into $430,000.
P.S. Despite the extreme volatility we've seen in the markets lately, it's worthwhile to consider what happens in the absence of volatility…
Which is why my colleague Jim Fink recently released a one-day trading strategy that generates profits when the market is just "treading water."
With this strategy, all you have to do is make one simple market move when my system says the outlook for the day is "flat calm"… and you're set up for the chance to bank gains of up to $1,230 or more before the end of the day (sometimes in a matter of minutes).
He's put all the details together in a special presentation you should see here.
