The Tide Has Turned: The Era Of Small Cap Outperformance Is Over

Includes: IWM, QQQ, SPY
by: Gerry Fowler, CFA

(Note that the following analysis was done using the underlying S&P 500 and Russell 2000 indices. The SPY and IWM are investable ETFs that replicate the indices with very low tracking error.)

For more than a decade, small caps (Russell 2000 - IWM) were outperforming large caps (S&P 500 - SPY). This outperformance reached 105% by mid 2011 but has since turned decisively in the opposite direction (10% so far).

(click to enlarge images)SPX (NYSEARCA:<a href='' title='SPDR S&P 500 Trust ETF'>SPY</a>) outperformance of RTY (NYSEARCA:<a href='' title='iShares Russell 2000 ETF'>IWM</a>) has returned and there appear to be structural reasons for this to continue

Over the last 30 years, several periods of significant large cap outperformance of small caps have occurred, however, and this has been driven by a variety of economic and supply/demand factors.

  • Changes in asset allocation ('86/ late 90s) - When money moves, it goes to the most liquid investments - large caps benefit most. The significant premium of the equity earnings yield to the US treasury yield in 1996 in particular looks like it was a major catalyst for a large asset allocation shift into equities that drove SPY outperformance.

Peacetime highs for equity earnings yields versus UST yields imply allocations away from equities could abate.

  • High savings rates ('84-'91, '08/'09) - When the savings rate is high, consumption is naturally lower and vice versa. The more domestically focused small caps (80% vs 60%) face growth headwinds as savings increase. From 1984 through 1991, the high savings rate contributed to small cap underperformance.
  • Low/declining housing starts ('84-'91, '08/09) - Much like savings and consumption influences, weak housing starts impact small caps more than large caps. Small cap indices tend to have higher consumer durables and domestic exposure. The decline in housing starts from 1984-1991 was a structural trend that kept a lid on small cap performance in comparison to large caps.
  • Low US economic growth ('08) - When economic growth is low, the more lofty valuations and high growth expectations priced into small caps are questioned and often miss by a wide margin.

Small cap earnings are more sensitive to low or declining GDP growth

Value and growth: The IWM trades at more than double the valuation of the SPY (28.2 vs 13.2x trailing PE) and implies growth of 50% versus the more realistic (less hopeful) 5.8% for SPY. With US growth likely to remain weak, the lofty valuation and growth expectations priced into the small caps look like headwinds to performance in comparison to the cheaper and more consistent growth of large caps.

Stars aligning for large caps: Many of the factors that have driven large cap outperformance in the past appear to be lining up in favor of large caps continuing their outperformance of the last 12 months. Allocations away from equities are slowing as the earnings yield premium to the UST yield reaches peacetime highs, the savings rate has bottomed and should trend higher, housing starts are very low and stagnant and economic growth is likely to remain low as fiscal issues start to be addressed from late 2012.

ImplementationGiven attractive implied volatility differentials, positioning for future large cap outperformance of small caps is favourable through call vs call exposure. Essentially, the SPY upside options price less significant upside probability than RTY upside options despite the headwinds for small caps explained above.

The SPX (<a href=

Buying the Dec-13 SPY 140 (105%) call and selling the Jan-14 IWM 85 (111%) call is roughly premium neutral but means investors get a 6% head start on SPY outperformance over the next 18-months. This is a very low risk trade given the 90% correlation between the indices. It is also a structural trend that should survive the likely volatility of the next six months around the election and debt ceiling/fiscal cliff debates.

Alternatively, replacing the SPY calls with QQQ calls (which has a higher weighting of attractive and more globally exposed technology companies) is a variation although the "headstart" is reduced due to more aligned option pricing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.