Riding the Smallcap/Largecap Cycle

Smallcap investors currently have a hard time. Cycles and periods of underperformance can be long and debilitating. This short post aims to help you understanding past cycles and what might be next.

To analyze the small/largecap cycle, I pulled the US Small-Minus (SMB) factor data from the Ken R. French database. The factor tracks the outperformance of the smallest 1/3 of US stocks over the largest 1/3 of US stocks. A simplified analogy would be a portfolio going long 100% IWM 0.00%↑ (Russell 2000) and going short 100% SPY 0.00%↑ (S&P500).

For the SMB factor portfolio, I calculated the 12-month performance, which marks a basic momentum definition, and the 120-month performance, which marks a common time frame for long-term reversals.

I then assigned each month to one of the following 4 cycle quadrants:

Thereby the borders were chosen so that they split the data in roughly equal parts.

• Peak: Cum. 120-month SMB performance is over 20% signalling a potential overheating in the cycle and a reversal being ahead.

• Trough: Cum. 120-month SMB performance is below 20% signalling a potential bottom in the cycle and a reversal being ahead.

• Decline: Cum. 12-month SMB performance is negative signalling a negative intermediate trend and potentially impairing conditions.

• Ascent: Cum. 12-month SMB performance is positive signalling a positive intermediate trend and potentially improving conditions.

If we plot the SMB portfolio chart and color-code the data points based on the conditional categories, we get a feel for the SMB cycle:

But can we use this method to “time” smallcaps and largecaps? Let’s have a look at the conditional performance statistics:

Key takeaways:

• Momentum (12-month performance) is a better predictor for future SMB performance than long-term reversal (120-month performance). High Momentum (ascent) resulted in similar high SMB performance both in trough and peak periods.

• The negative effect of bad momentum (decline) is worse in the peak of a SMB cycle (-1.4%). After long-term underperformance (trough), bad momentum (decline) becomes less predictive resulting in flat performance (0.2%). Naive conclusion:

  • Worsening trend after a Smallcap lost decade → Hold!

  • Worsening trend after a Smallcap bull decade → Sell!

• As one would expect, volatility was highest in violent reversal periods (“Peak / Decline” and “Trough / Ascent”)

Currently, we stand in the “Trough / Decline” quadrant. That means (without further information) that the best guess of near-term future smallcap performance is more or less tied to largecaps until we see a pronounced pick-up in momentum forcing the hands of market participants who neglected smaller stocks for so long.

So should you just wait for momentum?

Well, that’s one possibility. However, mean reversion (if it happens) can be fast and violent. Distinguishing a new trend from short-term volatility is hard and playing this timing game requires enormous discipline in a fast-moving environment with contradicting news from all sides.

Another way to play it, is to either just diversify into small AND large…

Or you just go with 100% smallcaps after seeing the stats above because the historical risk reward in “trough” periods is pretty good (either 1. small performs hand in hand with large up or down or 2. momentum picks up and smallcaps run).

Please note that all this only analyzes if and when smallcaps outperform largecaps. Outperformance can also just mean “losing less”. Most investors don’t run a long-short approach. In a long-only portfolio, whatever the stock market does as a whole will determine 80-90% of the performance. Furthermore, I only analyzed the aggregated performance in each of the 4 quadrants. A positive performance does not mean that there can’t be violent short-term drawdowns in smallcaps as seen in 2009 or 2020.

I can’t decide for you. I can only decide for me. And I am sticking with microcaps. Especially, considering that all I talked about in this post was smallcaps as a whole including all the junk. Now imagine what’s possible if you only buy cheap profitable small and microcaps…

I might have the same look at other factors like Value (HML) or specific portfolios (e.g. Smallcap Value vs. Market) in future posts.

Until then, I wish you good investing (or trading).