Will Small Cap Indexes Outperform Major Indexes in 2020?
Analysts are lining up to tell us that small-caps will be big in 2020, where we may expect the S&P 600 and the Russell 2000 to beat the S&P 500. Visions of sugarplums aren’t enough though.
Whether or not small cap indexes end up beating the large cap ones such as the Dow, the Nasdaq, and the S&P 500 next year, if we’re looking to predict such a thing, we at least need to ensure that our predictions are both reasonable and probable, more likely than not in other words, for anyone to expect that we should act on them.
We actually need this prediction to not only be more likely than not but be right by enough to compensate us for the higher risk that small-cap indexes have. Small caps both tend to go up more slowly and go down more quickly than large cap indexes, so in order to compensate us for this, we need a big enough expected advantage. Both of these shortcomings generally represent risks that need to be accounted for, and addition, given the very low probability of these events normally, we really will need some strong evidence to take this from very unlikely to very likely. This is a very tall order as it turns out.
These predictions at best are calling for a slightly better gain in 2020 for the small caps, a couple of percentage points at most, and this in itself too paltry to be noteworthy in comparison to the risk of this not happening and our coming out behind. We actually tend to miss by more than 2% on average so if this was a 50/50 situation it would be a mistake, and we’d need to be very sure of this to rightly want to take this gamble actually.
We do need to look at the rationale behind this to get a good idea of how probable this might be, and in particular, why these analysts even think that this is worth talking about, and a big reason turns out to be the perception that small-caps are hot right now and hotter than large caps.
If they finish the year hotter, the momentum may carry over to 2020, and perhaps their day in the sun will finally come. Many analysts love taking the side of the underdog and many make their living trying to sell dogs and will go to great lengths to come up with reasons to like them even though their thinking does not survive critical examination. They just look at things beat up and assume that some magical force will bring them back to their glory days, and those who just listen to them without question can end up buying into the whole charade and eventually pay the price.
If the rationale for small caps in 2020 actually does have some reason behind it, they will have to do more than show that small caps have gained 8% over the last two months versus the S&P 500 only moving up 7%.
There’s your heat right there, although we don’t have to do any math at all to know that this is just not statistically significant, especially since small caps have lagged so much and almost always do. You actually have to look hard to find any period where this team doesn’t lose, and when we do see a little better improvement like this, people get excited and start predicting a lot more of it.
Steven DeSanctis of Jefferies predicts a 7% increase in the value of small caps next year, and tells us that he thinks small caps are “primed to outperform as the economy and earnings improve in 2020.” Jill Carey Hall of Bank of America Merrill Lynch is also expecting an “economic recovery” next year and also believes that small caps will benefit more from it.
This all ties into the belief that after a downturn, small caps tend to rebound a little better in the early stages anyway, which can happen sometimes, or at least provide the illusion of better performance sometimes. Their most recent performance is evidence of this, and the reason is that small caps lose more during downturns, and while they finish lower than big caps after the rebound, they can sometimes move up at a higher rate during the reversal because they lost more.
In our example, small caps lost 3% more during the second half of September, and have gained back one of these three percentage points lost since. This is far from being hotter or even hot in any meaningful way, and especially not in one that would entitle us to project this forward, especially over a whole year.
We also need to ask where the weakness that small caps are supposed to rebound from is. This is the strongest stocks have been in history, at least with large caps, even though small caps were considerably higher in August of 2018. They are still trying to recover from that but this does not mean that large caps are in recovery mode or the economy is, as this is far from reality.
Perhaps they think that it is the economy that is in need of repair, but the economy is doing simply great and it’s even hard to come up with a theoretical model that is much better than this. We actually don’t want too much more growth in 2020 as that will cause the Fed to put rates up like they did last year for instance, and we know what that did to the stock market.
Small Cap Indexes Underperform in All Weather Conditions
It is not even that we can count on small caps to respond better than large caps in more prosperous times, and this is where the large caps really outdistance them. 2019 is a good example of this, where large caps have beaten small caps very convincingly, although you can look at any period in recent history and see them lag, because they naturally lag. In tougher times, they certainly will lead the way, but in the wrong direction.
Small caps never outperform large caps in a meaningful way over a long enough time to matter to investors, and this extra 1% gain and still being down 2% in the overall move during the last 10 weeks doesn’t count and far from it.
Beating the large caps over an entire year is particularly ambitious, and once again, we need a high level of probability here. Something that never happens anymore isn’t very high. This takes a very long shot and offers even money on it. Although that should strike us as plain stupid, they say there is a sucker born every minute and there are therefore quite a few alive who might want to follow this advice.
There are several good reasons why this bet would always be a long shot, but this mostly comes down to the way all these indexes are structured. Large cap indexes are more structured toward growth where the small cap indexes are set up to deliver less growth. It is therefore no surprise that during growth phases they grow less.
This is the part that causes them to not go up as fast as their big brothers, and it’s not even a fair fight. This manifests in less growth over any time period you wish to choose. If anyone thinks small caps do better in a period of growth, we’ve done plenty of that over the last 5 years, and the S&P 600 is up 38%, with the Russell 2000 doing a little better at 41%.
In comparison, the S&P 500 is up 57%, the Dow is up 58%, and the Nasdaq Composite is up 86%. These are the better times that the small-caps are supposed to beating these indexes, and although only the S&P 500 is mentioned as it often is, the fact that this could take on the Nasdaq during good times crosses over into the ludicrous.
The fact that they are speaking of an “economic recovery” at this point should scare us as well, perhaps even more than the fact that these dogs do worse during economic recoveries not better. We’ve well surpassed the high-water mark of last year with the large cap indexes, but the small cap ones have a way to go to make it just back up to there.
If their belief were true, we would have seen small-caps do better this year, not worse, and not considerably worse, because this definitely qualifies as a recovery year, but we have recovered and then some and this condition does not apply to next year. It’s hard to even call this view an illusion because illusions are similar in many respects to reality but this one simply doesn’t correspond to anything but bloated hopes based upon bad analysis.
If You Lose Both Ways, You Simply Lose
Investing in something that at the best of times goes up less and goes down more just does not make sense, not in 2020, and not ever. We can make a prediction out of this with the high level of confidence we need, which would be that these small-cap indexes can never be reasonably expected to outperform large cap indexes looking ahead to any given year, because this is not their history and if this did happen it would be a big outlier, and this may not even be possible anymore given the structure of these funds.
This would be like expecting the Dow or S&P 500 to beat the Nasdaq over a growth period for stocks, because the Nasdaq is more structured toward growth and if we’re growing, these stocks will grow more quite naturally. Anything other than this would be an accident, and if we bet on accidents, we may or may not part ways with our money but we’ll sure have less to brag about in the end.
Over the long run, the period that investors look at, this is where the advantage really gets expressed. Over the last 30 years, the Nasdaq has gained 10 times more than either of these small-cap indexes have managed. This wins big on any time frame, including the one over the last 2 months, the period that has some people excited about, with their 8% to 7% lead over the S&P 500. Over this time the Nasdaq has continued to stand tall with its 11% to 8% margin over small-caps. Year to date, the Nasdaq is up 11% more than the small-cap indexes are.
Even in a bad year like 2018 where the Nasdaq lost 5%, the small cap indexes averaged a loss of 10%, twice as much as an index which is so famous for being volatile. These small-cap indexes are even more volatile, to the downside that is, the side we don’t like. More pain isn’t better, less pleasure isn’t better either, and wanting both of these together is simply crazy.
The analysts may not have wanted to pick a fight with the Nasdaq, or perhaps they still might, but taking on the S&P 500 with their visions of small-cap sugarplums dancing in their heads as a counter to the way these indexes actually work falls flat enough on its face. We can’t just ignore the big gorilla in the room though, and even if small-caps were expected to beat the S&P 500, we’d still need to account for their expected performance against the Nasdaq, if we at least wish to advise properly and not just root or otherwise show prejudice.
It turns out that the main thrust of their beliefs relies to a large degree on their expecting that earnings will grow at a higher rate with small-caps next year. This is an entirely different tale, as this is not even correlated with stocks of the same type. Earnings growth is one of many influencers of stock prices and not even a particularly meaningful one, but if it were, we would see them beating large caps more often than never.
Focusing way too much on earnings and trying to ignore everything else is the bane of analysts, and the ignoring includes even taking a peek at how their beliefs correlate with reality. Whether or not small-caps will experience higher earnings growth in 2020 doesn’t even matter because even when they do, they lose. The main problem with this idea is that the market looks at the promise of earnings growth decades out and not just months out and this is why the Nasdaq kicks the other indexes because their future tends to be more promising than average and this gets priced in.
This is perhaps as close to a sure thing as we ever see, but we usually don’t want to be so sure of being wrong. This is terrible advice based upon a terrible understanding of stocks aimed at those who have an even more terrible understanding of them, who perhaps see these folks as wizards looking into the future. We don’t question the wizards anywhere near as much as we should though.
Editor, MarketReview.com
Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.
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