From the July 2009 issue of Boomer Market Advisor • Subscribe!

The boomer case for small-cap stocks

By Patrick Quinn

Investors often debate whether small-cap or large-cap stocks are poised to outperform within the broader U.S. equity market. This is especially true going into and coming out of a recession.

These debates often point to the direction of interest rates and the U.S. dollar, high-yield bond spreads, relative valuation and the economic environment as leading indicators of inflection points in the small-cap/large-cap cycle. Overlaying these metrics against the historical relative performance of small caps and large caps, however, reveals that some of these commonly assumed drivers are nearly irrelevant. We will debunk these factors, examine the more meaningful factors and point to why we believe small caps are poised to outperform in the current environment.

The strength of the U.S. dollar and the direction of interest rates have each proved poor indicators of small-cap relative performance. A weak U.S. dollar is often suggested as a catalyst to increase allocations to larger, typically multinational companies. But over the past 25 years, the greenback and small-cap cycles have had at times a direct relationship and at other times a dramatic inverse relationship. Another common assumption that has proven invalid is that falling interest rates propel small-cap outperformance, as these companies will benefit from less expensive debt to fund their growth. Plotting the Federal Reserve's interest rate easing and tightening cycles back to 1971 against small-cap performance cycles reveals that there is a very low correlation between small-cap relative performance and the direction of interest rates.

Compared with the metrics listed above, extremes in relative valuation, high-yield credit spreads and GDP growth have been more reliable - albeit still imprecise - indicators of small-cap cycles. Historical extremes in relative valuation have signaled inflection points in the relative performance cycle. However, identifying the exact top or bottom would have proved difficult, and investors would have faced steep penalties for prematurely calling inflection points in 1988 and 1999. Most importantly, current relative valuations are roughly in line with long-term averages and therefore should not be a catalyst for either size segment in the near term.

Plotting GDP growth against relative performance cycles suggests elevated levels of economic stress have preceded small-cap outperformance. Three of the four recessions between 1970 and 2002 coincided with the start or early stages of a small-cap outperformance cycle. And the fourth recession during this period saw the continuation of a small-cap cycle. Spikes in investor risk aversion, as measured by high-yield credit spreads, have generally been a time to begin favoring small caps. Credit-spread spikes in 1990 and 1999 coincided with the beginning of multiple-year runs of small-cap outperformance.

Perhaps the timeliest analysis in the current economic environment is one that compares small-cap with large-cap performance during and after the previous 12 recessions. Small caps have historically underperformed during the first half of a recession, while they have outperformed over the second half of a recession. Importantly, this outperformance has not been short-lived. For the year following the end of a recession, small caps have generally continued their outperformance.

We have examined potential drivers of small-cap versus large-cap relative performance. While there is a small sample size of inflection points in relative performance over the past 80 years, the evidence suggests that periods following elevated levels of stress and risk aversion, such as the current environment, have historically favored small caps. In the long run, earnings and cash flow growth drive stock price performance. This should favor small caps as it becomes increasingly difficult for many large-cap companies to find incremental growth opportunities, especially relative to their more nimble small-cap counterparts.

Patrick Quinn, CFA, is a small-cap equities specialist with William Blair & Company.

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