Is Large Cap Dominance Coming to an End?

The outperformance of US small cap stocks in the third quarter served as a good reminder that the small cap premium—though it has fallen out of favor from time to time over the past 100 years or so—has persevered over the long term.

Down more than 20% for the year to date through early April, the Russell 2000 Index has since rallied around 40%, including a 12.4% gain in the third quarter, outpacing the S&P 500 Index in both instances. This dynamic is worth noting given the chronic underperformance of smaller stocks since the financial crisis.¹ But does it represent a durable shift in relative performance toward the historical norm in which small cap stock have offered investors the potential for enhanced returns in exchange for higher perceived risk?

The rally’s persistence will likely depend on improved corporate fundamentals. Fortunately, we have begun to see just that. Amid a backdrop of 3.8% GDP growth and manageable inflation, Russell 2000 second quarter earnings growth came in at nearly 72% year over year, and estimates call for another 40%-plus expansion in the third quarter when reports start trickling out in the coming weeks. S&P 500 earnings growth, in contrast, was a relatively pedestrian 13.8% in the second quarter and is expected to slow into single digits in the third.² Earnings for small cap companies—who are far more reliant on floating-rate debt than their large cap counterparts—could get an additional boost from easing interest rates.

Given the size of the small cap market, recoveries can be sharp; it doesn’t take a massive amount of renewed buying interest to significantly move a market whose aggregate capitalization is less than that of several individual US stocks. Of course, there are a host of risks too numerous to mention in this forum that could disrupt this comeback.