Increasingly, investors are starting to wonder whether the party is over for small-cap stocks. After all, they have been enjoying a bull market for more than eight years and the Russell 2000 Index, which tracks small-cap stocks, has notched several all-time highs in recent weeks.
Those who believe all bull markets eventually have to end and the pendulum often swings too far in any one direction are becoming unnerved. But a closer examination suggests that today’s highs might still not necessarily be excessive; room for more growth might remain.
The reason for this assertion is that, although they have regularly been notching new highs in recent months, essentially small caps have been playing catch-up with large-cap stocks over the last six years. The large-cap stocks, as measured by the Russell 1000 Index, reached their all-time on March 24, 2000 when they were 233 percent ahead of their 1995 levels. At the same time, small-cap stocks were only 130 percent ahead of their 1995 levels.
Over the next six years, small caps edged higher and higher while large caps tended to remain flat.
Earlier this year small caps finally edged ahead of their larger brethren when measured over the last 10 years. By April 28, the small caps were 205 percent ahead of their 1995 levels whereas large caps were 192 percent ahead.
But just because small caps have pulled slightly ahead does not mean they are done growing in this market cycle.
Judging by figures from Ibbotson Associates, which date back to 1926, small-cap stocks historically have earned 12.4 percent a year against 10.7 percent annually for large-cap stocks.
But right now the figures show that over the last decade small caps have advanced at about the same rate as large caps. Since 1996 the Russell 1000 has grown at 9.1 percent a year and the Russell 2000 has grown at an annual average of 9.6 percent. The figures therefore put small caps below their historical 10-year average of 12.4 percent a year.
On the basis of these statistics, some investors might revise their views and conclude that – based on the historical returns, which might not be repeated – small caps have a long way to go before they are exhausted. In other words, they might conclude that they have not yet caught up.
An even closer look reveals another dimension. Most of the small-cap gains over the last six years have been in value stocks. The Russell 2000 Value Index is ahead 17 percent a year since April 24, 2000, whereas the Russell 2000 Growth Index has advanced 0.6 percent a year over the same time.
If history is a guide, therefore, it would indicate that small caps have room to grow and that the growth might take place in small-cap growth stocks rather than in small-cap value stocks. But, of course, just because stocks acted that way in the past does not mean they will do so again. The markets are always subject to unforeseen economic events and sharp swings up and down might occur.
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Contributor Erik Ogard is a portfolio manager at Tacoma-based Russell Investment Group. He is responsible for all of Russell’s small capitalization U.S. equity portfolios. He joined the company, which manages more than 180 investment funds and has $167 billion in assets under management, in 1995.