How Do Small Cap Stocks Perform in an Inflationary Environment?

We speak with Andy Hyer, client portfolio manager with Nasdaq Dorsey Wright, about how small cap stocks have been performing in the past years compared to large cap stocks, and how he thinks small caps will perform in an environment with rising interest rates and high inflation.
 
How did small cap stocks perform in the past year, and do you see their performance changing in the new year? 
 
The table below shows the performance of the Russell 2000 Index (small caps) and the S&P 500 (large caps) in each year since 2007 through 2021.  As shown below, small cap stocks have underperformed large cap stocks over the last 1, 3, 5, 10 and 15 years! That is quite a stretch of underperformance for small cap stocks.
 
Data going back 50 years shows that small cap stocks have outperformed large cap stocks by about 1 percent a year and that is what you would expect based on finance theory, which suggests that small cap stocks should generate higher returns than large cap stocks over long periods of time due in part to the higher risk associated with small cap stocks.

The question on investor’s minds is whether or not we are going to see reversion to the mean in the coming years with small cap stocks coming back in favor relative to large cap stocks.  The answer to that question is maybe. Nobody knows for certain what the next couple of years holds, but this dynamic of longer-term outperformance of small cap stocks and then this more recent stretch of small cap underperformance does suggest to me that it makes sense from an asset allocation perspective to strongly consider making sure you have adequate small cap exposure for the potential rebound.
 
Interest rates and inflation are set to rise even more in the new year. How do small caps perform in this type of environment? 
 
The Labor Department just reported that inflation as measured by CPI rose 7% in 2021, its fastest pace in nearly 4 decades. There is an ongoing debate as to how sustainable this inflation will be with compelling arguments from economists arguing that inflation will persist for quite some time while others are arguing that we are likely to see inflation decline from here.
 
The 10 Year Treasury Yield Index finished 2021 at 1.51% up from 0.92% at the end of 2021. And it has moved even higher in the first couple weeks of 2022.
 
Among the arguments for why small cap stocks may do better than large cap stocks in an inflationary environment is that it may be easier for smaller companies to pivot and make changes in this type of environment. It has been argued that smaller companies may be able to more quickly raise prices and alter where they source goods and materials.
 
I don’t think we can just look at historical periods of rising and declining inflation and make a certain forecast of how small caps will perform in the coming years, but a conclusion that I do think can be drawn is that over very long periods of time, there is a compelling argument for considering small cap exposure as part of an asset allocation. Part of the reason that I believe this is a timely topic is given the recent stretch of large cap outperformance, it has become very easy for us to become complacent about segments of the market outside of large caps---like small caps---that may offer good opportunities in the years to come.

 
Is there a specific market/stock/index in the small cap space that you think investors should especially keep an eye on? 
 
I’ll mention two ways that investors may want to consider adding to their small cap exposure.  The first is the Invesco DWA SmallCap Momentum ETF (DWAS). This is an ETF based on the Dorsey Wright Small Cap Technical Leaders Index, which selects about 200 small cap stocks out of a universe of approximately 2,000 that meet our relative strength criteria. The index is rebalanced on a quarterly basis. This is an ETF that has been in existence since 2012. More information about this ETF can be found here.
 
The second way that investors may consider adding small cap exposure is through our Fusion Small Cap SMA, which we recently introduced. This separately managed account strategy is jointly managed with Nasdaq Dorsey Wright and RiverFront Investment Group. This new initiative between our two firms is one that we are really excited about. An investment universe of about 2,000 U.S. small cap stocks is evaluated for this strategy. RiverFront provides value and quality scores on this universe and Nasdaq Dorsey Wright provides momentum and volatility scores. These inputs are used to select the approximately 70-75 securities for this portfolio.

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The information contained herein has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs.  Accordingly, investors should not act on any recommendation (express or implied) or information in this material without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions. Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources believed to be reliable (“information providers”).  However, such information has not been verified by DWA or the information provider and DWA and the information providers make no representations or warranties or take any responsibility as to the accuracy or completeness of any recommendation or information contained herein.

This interview originally appeared in our TradeTalks newsletter. Sign up here to access exclusive market analysis by a new industry expert each week. We also spotlight must-see TradeTalks videos from the past week.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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