Tuesday, June 06, 2006

Business Cycles and Large vs. Small Cap Performance

In the past 5 years, the Russel 2000, a yardstick for small-stock performance, is up more than 40%, while the Dow Jones, which tracks 30 of the nation's biggest public companies, has been about flat (read Diya Gullapalli's article on the June 5 WSJ Mutual Funds Report).

There appears to be cycles of performances between the two classes of stocks in the data. Large cap stocks tend to outperform small caps during periods of slow growth or recessions, and small caps outperform large caps when the economy is rebounding from a recession and its growth is greater than usual.

The argument for these cycles seems to be based on the fact that prices and revenues of small cap companies are more susceptible to business cycles than prices and revenues of large companies. A cited reason for this is that large companies enjoy economies of scale.

Another reason for this apparent performance is that small cap companies are usually companies with potentially fast growing profits and revenues. But growth prospects are uncertain and hard to estimate, and changes in growth prospects have large effects on stock prices. Thus, during economic contractions, when uncertainty about economic prospects is higher, small caps may take a bigger hit.

How can this be useful to investors? Given these cycles, the answer is obvious, one should invest in small cap funds or companies in expansions and in large cap funds or companies in contractions. Investors can take advantage of this strategy to the extent that we can predict expansions/contractions. Notice though the market would try to undo this profitable strategy with price changes: Prices of small caps would increase right at the beginning of an expansion, thus eliminating future capital gains. Under this hypothesis then, only unpredictable components of business cycles are responsible for the performance cycles. Thus, there is no way to take advantage of the performance cycles: small caps are simply a riskier investment opportunity.

According to this view, small caps should earn a greater long-run return relative to large caps, in compensation for the extra risk. This is indeed the case in the US, where in the last 80 years or so small caps have outperformed large caps.

Notice this type of "efficient market" type of analysis is based on two testable implications: that small companies profits are more strongly procyclical, and that their prices react to changes in expected growth prospects of the company. I am not sure we have direct and convincing evidence on these.


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