Small-Cap Performance Edge on the Wane

Tim Strauts: In today's chart, we are going to look at large-cap versus small-cap trends in performance since 2000.

The chart depicts excess return of small- over large-cap U.S. stocks, in which we take the return of small stocks minus the return of large stocks. And if the number is positive, that means that small-cap is outperforming large-cap. If the number is negative, large-cap is outperforming small-cap.

So, the dark-blue-shaded area is small-cap outperformance. And the light-blue-shaded area depicts large-cap outperformance. The strong outperformance of small-cap since 2000 is mainly due to the tech bubble, when U.S. large-cap stocks became extremely overvalued. This valuation advantage allowed small caps to outperform over the next 14 years. The periods where small caps underperformed were during periods of high volatility and market declines, which we saw in 2007, 2008, again in 2011, and most recently, in the last few months of 2014.

Looking at the table of returns, we can see that in the third quarter of this year small caps had a negative 6.2% return, whereas large caps were positive 1.4%. Over the trailing one-year period, small caps had only returned 7.7%, whereas large caps returned almost 20%.

This outperformance is due to the increased volatility I mentioned earlier and a slight valuation advantage for large caps. Small caps currently trade around 21 times earnings and large caps only trade at around 18. So, the valuation advantage that small caps have had over the last 14 years is no longer prevalent.

Going forward, I would expect that the small-cap and large-cap returns will fluctuate on a much more frequent basis, with small caps no longer having the big advantage.