Is This the End of the Small-Cap Cycle?

Feb.26.08 | About: SPDR S&P (SPY)

One of the market anomalies that can’t be easily explained by the Efficient Market Hypothesis is the out-performance of small-cap stocks.

Still, I’m not much of a believer in the small-cap effect. The data is clear that it exists, but I suspect that much of the out-performance is simply a matter of liquidity. Also, the out-performance is very small and highly volatile. Small-cap stocks, as a whole, can lag the overall market for many years. In fact, the small-cap cycle has historically run about five to seven years. That's a bit long to base a trading strategy on.

The graph below is a good proxy for the small-cap cycle; it shows the Russell 2000 divided by the S&P 500.

The small-cap cycle peaked on March 25, 1994, after which, small-cap issues declined until April 8, 1999. Notice that this happened while the rest of the market was still climbing.

From that low, small-caps have had a great run, but that run could be over. The ratio hasn’t been able to surpass its high reached on April 19, 2006. This has now been almost two years. Of course, we never exactly know when a cycle has reached a turning point, but it's perfectly obvious in hindsight.

I suspect that the cycle has turned in favor of large-caps. A major reason is that larger stocks offer more safety and that’s definitely on investors’ minds. Naturally, some of the worst abusers of the sub-prime mess have been large-cap stocks. Or at least, they used to be large-cap stocks.