Interesting convergence between small and large company stocks

Market cycles and trends are dynamic, ever evolving, so labels such as big and small are subjective, relative, and change over time. Everything is impermanent, so nothing lasts forever.

Investors expect smaller companies stocks to offer greater potential returns over the long-term, but they may come with greater risk compared to large-cap companies. Because smaller faster growing companies are considered more risky, they also require a higher expected return as the “risk premium.”

The Russell 2000® Index measures the performance of the small company stock segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

According to the index provider, the Russell 2000® is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.

The Russell 2000 tracks the roughly 2000 securities that are considered to be US small cap companies. The Russell 2000 serves as an important benchmark when investors want to track their small cap performances versus other sized companies. The Russell 2000 tends to have a larger standard deviation in comparison to the S&P 500. However, it also is expected to yield larger returns in positive market environments. The reasoning is smaller companies are in a more aggressive growth phase of a business cycle and small companies are more nimble than large companies to take advantage of opportunities. It is also widely believed small-cap stocks have historically achieved better relative momentum early in a new cycle when liquidity is cheap and overall growth rates are faster.  Small-cap companies may also be less affected by global trade conditions given their businesses are more domestically driven than large companies that do business globally.

Indeed, up until March, the chart below comparing the relative strength of the price trend of the Russell 2000 small cap index relative to the S&P 500 weighted more toward large companies shows small companies outperformed larger companies significantly.

However, that has not been the case since the small stock index peaked in March. As I highlighted in yellow, the Russell 2000 has been drifting sideways into a five month long base without a breakout.

In the meantime, the S&P 500 stock index has trended up with decreasing volatility.

What we observe now is a convergence between the two. The S&P 500 is catching up as the Russell 2000 drifts in a non-trending state.

If the market generally believes small company stocks will outperform in the early stage of a new economic expansion and business cycle because they may respond to new positive conditions faster and potentially grow quicker in young bull markets, then this recent relative underperformance the past five months may be bearish sentiment.

It’s going to be interesting to see how this unfolds. It may be a an early warning of a market top, at least temporarily. Then again, if the Russell 2000 can break out of this base to the upside (instead of the downside) it could eventually bring the large companies with it.

A rising tide lifts all boats, so the saying goes, and it sometimes applies to stocks participation in market trends.

We’ll see…

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.