While every market participant watch the major indices, more astute ones also pay attention to the relationship between markets in order to glean more insight. Well-known examples include bonds vs stocks, cyclical stocks vs defensive stocks, and the U.S. Dollar vs the Euro. Another important inter-market relationship is the ratio between small-cap and large-cap stocks.
Market participants should pay attention to this relationship to get insights on risk appetites and breadth. Many major rallies and declines in history were preceded by long periods of small-cap underperformance or outperformance. Small-cap stocks are usually bought at an individual, bottom-up level for investment purposes, as they are less liquid.
The money tends to be stickier. Thus, strength in small-cap stocks is seen as a bullish omen, since investors putting money to work in riskier, less liquid situations is a vote of confidence. This correlates to risk-on environments. These environments tend to have trending bull markets over many months or even years.
Typically, small-caps outperform during periods of accelerating growth, since they are more leveraged to the domestic economy. In contrast, large-caps are better insulated from economic shocks, since they tend to have bigger balance sheets and more diverse sources of revenue.
When economic growth slows, small-caps are hit hardest, since they tend to see the sharpest drop in revenues and are much more likely to go bust. Large-caps also see revenue drop in recessions, but the drop in interest rates leads to lower borrowing costs which have an ameliorative effect. Additionally, they tend to have the resilience to survive these conditions, putting them in a position to gain market share and pick up assets at a discount.
Current Market Landscape
Small caps began underperforming large caps in mid-2018. Notably, this was before the broader market turned lower in October amid escalations in the trade war and a hawkishly positioned Fed. This underperformance persisted until September of this year. For the last three months, small-caps have outperformed and this has translated into market conditions where stocks across all sectors are seeing sustained gains.
The most logical explanation is that investors are moving into a period where they expect economic growth to accelerate following a 15 month period where they expected growth to slow. Although the economic data is not decisively confirming this outcome yet, other asset markets are reflecting similar optimism including strength in cyclical stocks, semiconductors, and the steepening of the yield curve.
