The sharp rally in US small-cap stocks has hit the headlines. By July 16, the Russell 2000 (“R2”) index, which measures the US small-cap sector, had jumped more than 11 percent in just five trading sessions.
“Rotation trade takes small caps from dead money to Wall Street darlings”, Reuters wrote last week.
Small caps are regarded as particularly sensitive to interest rates, and the latest market move reflected renewed optimism about the pace of future rate cuts. During the first two weeks of July, the Fed Funds futures market moved to price in an additional 25-basis point cut (to 4.75%) by the end of the year.
Market commentators also attributed the speed of the small-cap upturn to a rotation out of overbought large-cap tech stocks and to short covering in Russell 2000 ETFs.
But how does the rally look against longer-term trends? Here are statistics to put the current small-cap rebound into perspective.
Small-caps have outperformed for two-thirds of the last century
In a famous paper called “Common risk factors in the returns on stocks and bonds”, published in 1992, Kenneth French and Eugene Fama provided empirical evidence for the existence of the “size factor” – a persistent and positive return premium earned by small-cap US stocks over their large-cap equivalents.
French’s data library at the University of Dartmouth goes back nearly a full century. He calculates that US small caps have outperformed large caps around two-thirds of the time – and by 2.85 percent a year, on average – between 1927 and 2023.
Periods of outperformance by large caps do occur, and we’ve just seen one of the most dramatic periods of outperformance by the biggest tech stocks. According to French, the ten-year rolling performance of the of “small minus big” size factor was negative (i.e., large caps outperformed) between 1954-1964, 1990-2002 and, most recently, since 2019.
However, small caps have tended to offer a return premium for the rest of the time.
Rolling Ten-Year Performance For US Size Factor (%)
Source: Kenneth R. French Data Library. Annual returns from 1927 to 2023. Please see the end for important legal disclosures.
The last 45 years are more ambiguous
The Russell US indexes are celebrating their 40th anniversary this year, and the index history goes back to the end of 1978.
That history tells us that over 45 years, the returns of US large-cap stocks and US small-cap stocks have been broadly similar: the Russell 1000 (large-cap) index’s price return was 9.26% a year between the end of 1978 and June 6, 2024, while the Russell 2000 index’s return was 9.01% a year over the same period.
If you added in dividends (in the form of the total return index), the Russell 1000 pulled a bit further ahead of the Russell 2000 over the 45-year period. But overall, the two indexes’ price returns are similar.
Return and Risk Since Inception – Russell 2000 vs. Russell 1000
| Index | Return p.a. | Standard deviation of daily returns (annualised) |
|---|---|---|
| Russell 1000 price index | 9.26% | 17.54% |
| Russell 1000 total return index | 12.13% | 17.54% |
| Russell 2000 price index | 9.01% | 20.01% |
| Russell 2000 total return index | 10.87% | 20.01% |
Source: FTSE Russell, daily index data from 29/12/1978-07/06/2024. Please see the end for important legal disclosures
Small-cap performance is highly cyclical
What is clear from the Russell index data is that small-cap performance is highly cyclical.
US small caps outperformed large caps between 1978 and 1982 and between 1998 and 2010 (these periods are marked by green arrows in the chart). Small caps underperformed large caps between 1982 and 1998 and from 2010 to date (these periods are marked by red arrows in the chart).
Relative Performance – Russell 2000 vs. Russell 1000
Source: FTSE Russell, ratio of the performance between the Russell 2000 and the Russell 1000 index. Daily index data from 29/12/1978-07/06/2024. 29/12/78=100. Please see the end for important legal disclosures
Time will tell if the early July 2024 rotation into US small caps marks the beginning of a new upwards trend in relative small company performance. However, what is clear is that once such trends start, they often continue for several years.
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