Can Small Caps Rebound?

money and investingOne 2015 surprise: A stronger dollar hasn’t led to small-cap outperformance. Russ explains why and what this means for the small-cap tilt heading into 2016.

Margo Harrison / Shutterstock

Margo Harrison / Shutterstock

If there was one strong consensus view coming into 2015, it was that the dollar would rise. In this instance, the collective wisdom was correct. The U.S. Dollar Index (DXY) is up roughly 10 percent year-to-date, according to Bloomberg data.

However, while the consensus was right on the direction of the dollar, it was wrong on at least one implication of a stronger greenback: small-cap outperformance.

The Large-Cap/Small Cap Dynamic

Many investors assumed that a strong dollar would provide more of headwind for large-cap companies, allowing small caps to outperform this year. But while large-cap earnings have been dented by the dollar’s strength, Bloomberg data show that the large-cap S&P 500 Index was outperforming the small-cap Russell 2000 by more than 300 basis points (bps) through late November.

What went wrong, and how should investors think about the small-cap tilt in 2016?

In terms of what went wrong, it was the value side of the equation. Since the start of the year, the trailing earnings multiple on the S&P 500 has nudged higher, advancing approximately 2.5 percent. In contrast, the price-to-earnings (P/E) on the Russell 2000 has contracted by around 2 percent.

The relative performance of small and large caps against financial market conditions helps to explain these shifting valuations.

While a stronger dollar provides less of a headwind for small-cap companies, the dollar has been strengthening in the context of pending Federal Reserve (Fed) tightening and less benign credit markets. The latter point is particularly important for small caps, which perform best when credit conditions are easing.

There are several interpretations for this phenomenon. Small-cap firms are more of a credit risk, so the availability and ease of financing is more critical for these companies. Another mechanism is market sentiment. Small caps are generally considered more speculative. In an environment in which credit conditions are easing, volatility is typically lower and investors are more willing to embrace risk.

History supports this thesis, according to an analysis using data accessible via Bloomberg. Looking back over the past fifteen years, in months when high yield credit spreads were widening, indicating tighter financial conditions and more risk aversion, the S&P 500 outperformed the Russell 2000 by an average of roughly 0.45 percent.

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