The Real Reason Small Caps Underperform So Much
It is believed that small cap stocks lose more during pullbacks because they are smaller and therefore more sensitive to economic downturns. The real reason is simpler than that.
It shouldn’t be as difficult and complicated to understand the movement of stock prices as we try to make it. The issue with small caps unsurprisingly losing more money during our current downturn in stock prices provides us a good opportunity to better understand these things, although this isn’t difficult to do anytime and it just involves us looking at why stock prices go up or down at all.
This just requires that we have the most basic understanding of economics, the sort that they teach in the most elementary courses. Economics is at its most fundamental level a study of the relationship between supply and demand, and this relationship determines the price of everything, and wholly so, including and especially including the price of stocks due to the way that they are traded, in very accessible and liquid markets.
If we have a car to sell for instance, while the price will depend on supply and demand, the market for used cars is nowhere near as efficient as with stocks, and therefore the price we get will depend not only on the demand for it and what we may wish to get for it but the limitations of the market.
We might just go to the dealer and negotiate a price based upon the amount of demand at that level, or we may offer it for sale on the local market, but this will not necessarily provide us with the best price, as there may be many people out there who would pay more for it had it been offered for sale to them. Someone in another city may be looking for the exact same car and pay more for it than you sold it for, and if both you and this buyer had been brought together, you both would have been made happier, but were instead constrained by market limitations.
Supply and demand are therefore constrained by markets, and we really see this when trying to move privately held stock, where trading it is very limited. This is the main reason why companies issue public stock by way of IPOs, so the reach of their stock can be greatly expanded, making it readily available to anyone with a brokerage account and a desire to own it.
This is where the greatly enhanced accessibility of stock on public exchanges come in, which brings together buyers and sellers of stock and allows supply and demand to be extended out to the entire potential market, not just be limited to a few buyers and sellers as is the case with private transactions.
What sets stocks apart from most goods, like our used car, is their fungibility, which means that one instance of an asset is interchangeable with another. We have this with commodities, where one ounce of gold or one bushel of wheat is interchangeable with another, not meaningfully distinct in other words, but stocks are completely fungible, being identical to one another.
This allows shares in a company to be exchanged with no regard to quality, unlike with used cars which will differ widely in this aspect. We need this, otherwise we’re just dealing with many fragmented markets, like we do with cars of various qualities and conditions where we are essentially stuck with comparing the supply and demand of a lot of different things rather than having the market homogenous like we have with the market for a stock.
In order to efficiently trade stocks, we also need price transparency. We may not know that much about how much people are paying for our used car, even though there are online sites nowadays that can give us some idea, but if we could know exactly how much these cars sell for, and especially what the best offer is for it at any given time, this would be very helpful. This is one of the things that exchanges provide us, by not only telling us how much someone is willing to pay right now, they also tell us where the price has been trending and allow us to either sell it now or speculate that its price may continue to rise as demand builds.
The exchange mechanism itself therefore stimulates speculation, especially since we can even see these prices move in real time on our computer screens. The price trends that we view on charts represent changing dynamics with supply and demand, and seeing these prices move in itself changes levels of supply and demand, where rising prices tend to stimulate more demand and falling prices tend to decrease it. This is not anything you could ever understand looking at balance sheets or anything else, and can only be discovered by looking at the supply and demand for a stock itself.
Prices in general represent the equilibrium of supply and demand at any given point in time, even though there are often market inefficiencies involved. People might pay more for gas in one part of the city over another, and not be aware that they could drive a few extra miles an save some money for example.
Stock markets have the benefit of efficiency due to using technology to broadcast trades on the internet as well as in private networks, and while some assume that the price that a stock trades at is the sum of all information about it, it’s more like the sum of all the forces of supply and demand upon it at any given time.
This is by no means the same thing, and the first big lesson for us, and the one that a lot of people who earn their living looking at stocks really miss. The idea that small caps are more sensitive to economic conditions is an example of this, and even though analysts such as Lori Calvasina of RBC Capital Markets are sticking with this story, stocks are not sensitive to anything but supply and demand for the stocks.
Calvasina’s is a pretty typical view actually, and the flaw here is thinking that economic conditions or business conditions or anything but supply and demand directly affect stock prices. They can affect demand, but do so in an indirect way, where investors may become more worried about smaller stocks when these things happen and that can reduce demand and increase supply, in other words, cause less people to want to buy them and more people to want to sell, as well as influencing the price that they are willing to buy and sell them for.
This might sound like the same thing, but it certainly is not. As it turns out, small caps are not more sensitive to economic changes by way of the economic changes themselves, they suffer more because the demand for them is less and there is less optimism to lose. They are actually less sensitive to positive changes though, which is the assumption that many people might make even though it is not correct. There is less optimism to be gained from this as well, and less optimism overall, leading to less price performance.
Stock Prices are Always Driven by Relative Demand, Completely in Fact
Small caps both go up less and go down more, this model only provides an explanation of one side of this and has the other side contradict it, because if your stocks are more sensitive to change, this would cause them to go up more. The only explanation that makes any sense is that small caps simply do not have the same level of demand that large cap stocks do generally, where this lesser demand both drives their prices up less, and sees their prices go down more when things are turning downward, from less demand to support the stock.
Once we understand this, we can now understand much better why small caps are simply inferior to large caps, and why performance bears this out so much. This does not mean that a particular small cap stock will always underperform large cap averages, but the good small caps will underperform the good large cap ones, and the reason for all of this is the same, less demand.
We don’t even need to go into why small caps have less demand behind them, because if they don’t, that alone is plenty to have us turning away, but only if we understand this. A lot of investors don’t get this and will own these stocks in the hopes that their ship will come in, from perhaps thinking that their smaller size offers more growth potential. That might be true for the company but is only the case with the stock if this causes the stock to be in greater demand than a comparable large cap one, and since demand affects price directly, this ends up being a false hope.
We should not be scratching our heads as some are when we see the S&P 500 gain 3% last week while the small-cap Russell 2000 went down by 1.4%, because that’s just now these things usually work. We definitely don’t want to read too much into such a thing like Calvasina does, thinking that this is somehow indicative of “how severe the economic damage has been,” because we’re only looking at demand for types of stocks, not economic damage.
Demand for stocks is influenced by a number of things, and beliefs of economic damage are certainly among them, but even if they believed that small caps will take a bigger hit from this than large caps, which they certainly might, this does not permit us to assume that more negative beliefs about small caps mean that we should somehow have more negative beliefs about large caps as a result.
All we can say from this is that the demand for large caps is greater than with small caps, because that’s what the price divergence is telling us, and this is a story that is told all the time when we compare how these two types of stocks perform against one another. When we do, the only lesson here is that we should avoid small caps during both good and bad times, because they just don’t measure up, not last week, not at any time.
We have pointed this out in several other articles where we have compared the two, and the story remains the same in 2020. It’s not even hard to figure out why this is the case, and it has everything to do with now desirable investors see large caps over small caps, which is story that continues on in both bull and bear markets, because it is the lesser demand that causes these divergences.
We put a lot more money in big caps, it’s as simple as that. People who invest in index funds, for instance, put more money into big cap indexes such as the S&P 500, the Dow, and the Nasdaq than they do the Russell 2000. The comparison isn’t even close.
Going back to our intro economics lesson, greater demand will always cause higher prices, and this is also the case comparatively speaking. If we compare two stocks, with one being under greater demand than another, the one with the higher demand will trade higher every time.
Within the realm of large caps, there are plenty of stocks that are not in demand, the energy sector or the retail sector in general for instance, and we need not look any further to explain their disappointment even though we can look at the business results and they often correlate Sometimes they don’t though, due to certain sectors just being relatively out of favor, and given that all stocks compete for our investment money, a sector can be making plenty of profit yet this profit just is not comparatively reflected in its stock price, with good companies seeing their stocks go down often times. This is why we see such big differences in price to earnings or price to book value ratios, which reflect differences in demand essentially.
This also happens in the aggregate, with the stock market as a whole, where companies can be doing fabulously but reductions in demand toward stocks in general can see their price going down. There are countless examples, but one of the best ones is how Amazon lost 21% recently even though during this time, it has seen its business explode. Amazon during the coronavirus scare might be the most dominant stock ever, where this has been great for business for them while just about every other business took a hit from this.
You certainly can’t explain this 21% loss by business performance, when the business grew so much, but given that the aggregate demand for stocks got reduced so much, they went down with this big ship for a while. When the ship levelled off, and aggregate demand rebounded, they quickly rose and got much more than their share of this ramped up demand for stocks, as would be expected.
While it may not seem fair to compare Amazon with the Russell 2000, it actually is fairer than we might think, because we could choose either to put our money in. This will at least serve to show how much difference in demand with stocks can make, and we’ll go back 5 years to see how each has fared.
The Russell 2000 is down 3% over the last 5 years, and this has been during a time where large caps have grown in value considerably, so that’s actually pretty shameful and very undesirable. The Nasdaq, in comparison, is up 74% over this time, but Amazon leaves both in the dust with their 598% gain.
Now that’s a stock that has been in demand. We’ll set that aside and just compare the Nasdaq and the Russell 2000 though because this does not involve any stock selection at all, or any thinking really other than wanting to have your money in an index that is more in demand versus one that is not and is a perennial dog. We would not think that this would be a difficult choice, but it is among those confused enough.
It’s common knowledge that the Nasdaq goes up more on average than the other two large cap indexes, but what tends to worry a lot of investors is that it also goes down more, even though not by a very remarkable amount. It is the net amount we need to be looking at here, where these things do once all the hills have been gone up and down, and the Nasdaq beats the other two by a good margin.
If we look at where both were in August of 2018, before the move down that year, until today, where we get some real hills along the way, this will also give us a sense of how the two compare, how much more Nasdaq stocks have been in demand over this time, with overall demand fluctuating so much.
The Nasdaq is up 7% from its peak of 2018, while the Russell 2000 is currently off its 2018 peak, by a full 30%. That’s two bears and a bull, and the bears both hurt small caps a lot more and the bulls help them a lot less, not a desirable combination by any means.
We’ve pointed this out before, but the new data from this year makes this even clearer. The Russell 2000 dropped by 41% this year at its lowest point, while the Nasdaq only dropped 29%. Since then, the Russell 2000 is still down 28% of this, while the Nasdaq only sits 11% off their high for the year.
Why anyone would invest in something that goes down more and up a lot less remains quite a mystery, and the only explanation is that these people not only don’t understand how stocks really work, they aren’t even paying attention either.
The Russell 2000 underperforming big caps isn’t a surprise, it’s just how these things work. This index is crappy in all weather, including when it rains this hard, and this should neither surprise or concern us.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
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