When it comes to stocks, size matters. Since 1999, the small-cap Russell 2000 index returned nearly 60%, while its large-cap counterpart–the Russell 1000–has managed only a 14% gain. This is no one-time fluke: the little guys have beaten their larger rivals in every calendar year of the new millennium.
The graph below shows the return differential between small-cap stocks versus large-cap stocks. There is a clear tendency for leadership to run in trends, as the current six-year winning streak for small caps was preceded by a five-year run by their larger brethren. An obvious return advantage awaits those who can figure out which group is most likely to rule the roost.
The direction of interest rates is a common input in this decision-making process. Larger companies tend to go to the capital markets for their financing, usually fixed-rate securities. Smaller companies must use banks for the majority of their needs, and these loans usually contain a variable rate component. As a result, the earnings of smaller firms should be more sensitive to rate increases than large firms, making them inferior investments in rising-rate regimes.
To test this hypothesis, we ran a simple regression to determine just how stock price varies as rates rise. The results came out as expected, with smaller stocks definitively feeling the heat during rising-rate conditions, but the fits are not tight enough to be statistically significant. The current hawkish mood of the Fed clearly gives small caps the nod, but there are other factors to consider in picking one group of stocks over another.
