The Small Cap Rotation

Small Cap Rotation

One reason to own asset classes others ignore is because it often takes little positive news for the tides to turn.

Small caps are one such example. Large pools of investor money have mostly been ignoring small caps.

There are valid reasons: underperformance being the most obvious.

Pain from rising rates (small caps hold more floating-rate debt, which becomes more expensive as rates rise) has been a significant factor driving that.

From an investment perspective, small caps can be characterized by The Three U’s: unloved, underperforming, and undervalued.

Unloved: interest from active managers been in a consistent decline.

Underperforming: small caps have played little brother to large caps for nearly a decade.

Undervalued: when you combine the first two, the result has been much cheaper valuations.

From July 10 through July 31, small caps returned more than 12%, per Morningstar data. Such a return would be impressive for an entire year, let alone a few weeks.

As they say, there are weeks where years happen, and that’s what took place in the middle of July. Small caps outperformed large caps by ~10% in July. This was the single largest month of outperformance since December 2000.

Meanwhile, large caps have been experiencing something they haven’t in a while—a drawdown.

The Nasdaq had a peak-to-trough decline of 9% in July, while the S&P 500 experienced a 5% decline. (Note: these drawdowns have become larger in first few days of August.)

Additionally, on July 24 the S&P 500 saw its first trading day with a loss of more than 2% in nearly 18 months. One trading day means nothing over an investing lifetime, but lifting the hood on that day paints a sobering picture.

Four of the Magnificent 7 (Mag 7) companies declined by 5% or more on that day.

Printers have run out of ink discussing how much of the market's strong performance has been driven by the Mag 7. But the same is true on the downside.

Nvidia had a peak-to-tough drawdown of 23% over 14 trading days in July.

Of course, anyone would happily take that decline in Nvidia for the returns that preceded it. In fact, Nvidia has gone through a ~40% drawdown when you include August, and the stock remains up more than 100% YTD. But the point remains, risk happens fast and that’s why diversification is critical. 

And while it’s nice to see the benefits of diversification working, nobody deserves a parade for a few strong weeks of performance.

The question now becomes: Have small caps run too far, too fast? While unsatisfying, the answer would be: It depends.

If you’re a day trader, maybe it has. An asset class that went up 12% in a month probably isn’t the best bet if you’re looking to earn another 12% next month.

But if you allocate based on probabilities and market history, optimism remains that this rally might have a new pair of running shoes on.

For example, small caps are now up ~30% since their October 2023 low.

Looking at other major cycle lows in small-cap history, the average move higher 175 days later has been ~45%. And if you stretch the time horizon to 250 days, the average move higher has been ~60%.

Furthermore, using data from Carson Group, they identified the 10 best two-month periods for small caps ever and examined the subsequent returns. One year later, small caps were higher 8 out of 9 times, with an average increase of nearly 28%.

Put simply, it’s possible July was the start of a rally, rather than a unique one-time event.