The returns of small-company stocks have historically been either roughly equal to, or superior to, those of large-company stocks (depending on the period examined and the studies you choose to focus on).
This has been true when looking all the way back to the earliest "good" data on the stock market that starts in the 1920s, and has also been true as recently as the last time we updated The SMI Handbook earlier this decade.
In the Handbook’s (p.170) discussion of SMI’s Just-the-Basics strategy (JtB), there’s a table covering the 2003-2012 period. That table shows the 10-year annualized performance of JtB’s smaller-stock component as +10.6%, while the S&P 500’s performance was just +7.0%. Even during the current bull market, smaller stocks had the upper hand in four of the first five years (2009, 2010, 2012, 2013).
But then the tables turned. Radically. Large-company stocks have performed much better than small-company stocks since 2013. And this has been a significant issue for the returns of JtB and Fund Upgrading, which both weight smaller-company stocks highly. This weighting has been an advantage for SMI’s strategies for most of SMI’s history, but has been a significant drag on returns over the past several years.
Consider the following table. It shows the annualized returns of the two funds used in JtB for large- and smaller-stock exposure (VFIAX and VEXAX), as well as the result of the Russell 2000 (small-cap) index, through last night’s close (11/5/19).
| S&P 500 (VFIAX) | Ext Mkt (VEXAX) | Russell 2000 | |
|---|---|---|---|
| 1-yr | 14.6 | 8.8 | 4.9 |
| 3-yr | 16.1 | 13.7 | 12.7 |
| 5-yr | 10.9 | 8.6 | 8.0 |
| 10-yr | 13.5 | 13.1 | 12.2 |
| 15-yr | 8.9 | 9.4 | 8.2 |
A few things jump out from this table. First, the gap between the S&P 500 (large stocks) and the Russell 2000 (small stocks) over the past 12 months is breathtaking, at almost a full 10%. Adding mid-caps to the Extended Market fund helps close that gap a little, but even there the gap is huge. It’s been all S&P 500 for the past year.
Second, the gap remains significant over the past 3- and 5-years. The gap narrows quite a bit by the time we get out to the 10-year returns, but not completely. The way to read this is that the advantage small stocks had in the opening years of this bull market wasn’t quite as great as the advantage large stocks have had since leadership shifted roughly half-way through. Taken together, this chart (and this paragraph) explain most of the underperformance of JtB and Fund Upgrading relative to the U.S. Stock Market over all performance intervals out to the past 10-years. That strategy underperformance is very directly attributable to small (and foreign) stocks lagging the returns of the largest stocks, with most of that underperformance happening since 2014.
This is how our quarterly reports can show that Upgrading is adding value within the individual risk categories, yet Upgrading still show trailing performance relative the market as a whole. For example, Upgrading has outperformed the average fund in four out of five stock risk categories in each of the past two quarters, yet Upgrading trailed the market by a 5.25% - 4.50% margin over that six-month span. When you consider that the Russell 2000 actually lost -0.4% over those six months, the question isn’t, "Why did Upgrading lag?" but rather, "How did Upgrading manage to keep the gap so small?"
The true extent of recent small-cap underperformance is seen in how much better the returns of the center column (Vanguard’s Extended Market fund) are than the far-right column (the true small-company stock index). Both JtB and Upgrading get around the worst of the small-cap underperformance via their use of so-called "mid-cap" stocks.
In JtB, this is overt, as the Vanguard Extended Market fund includes both small- and medium-company stocks. Upgrading doesn’t overtly include mid-caps, but does allow significant leeway in its risk categories, so that it’s possible for our small stock categories to own funds that bump right up against the cutoff between the small and large categories. This helps Upgrading in situations such as we’ve had in recent years (and provides an answer to the question posed at the end of the last paragraph).
Finally, the last row of the table shows the returns of the S&P 500 and Russell 2000 narrowing to just 0.7% over the past 15 years, in spite of the huge advantage large stocks have had over the past six years of that 15-year period. Adding in the mid-caps, the returns of the Extended Market fund are back on top by the time we extend the period out to 15 years.
All of this is extremely significant in terms of how we interpret the recent performance of SMI’s strategies. There’s a natural tendency to see the underperformance of Upgrading in recent years and wonder if the strategy is "broken" or just doesn’t work the way it used to anymore. Yet the table provides an explanation of why Upgrading’s returns were so much better than "the market" in the years leading up to the last bear market, as small and foreign stocks outperformed large stocks during that period. And it also shows that Upgrading’s primary problem since than has been the lagging performance of small stocks starting in 2014. When smaller stocks were at least holding their own, Upgrading did too, outperforming the market in three of the first five years of this bull market.
What’s next?
Naturally, the pressing question is why have large stocks outperformed by such a large margin lately, and what are the prospects for the future? Obviously, if this is a condition that is likely to continue, we wouldn’t want to persist in weighting small stocks so highly in our portfolios.
There are any number of factors that could be contributing to the recent performance gap. Some speculate that the rise of 401(k) plans has created a dynamic in which more and more money gets funneled into the largest stocks due to the market-weighted construction of the most popular indexes.
Another plausible piece of the puzzle has to do with the massive corporate buybacks of stock in recent years. The incredibly low interest rates we’ve experienced have made it cheap for companies to borrow and use those funds to repurchase shares, reducing the volume of shares outstanding and increasing earnings per share, all the while putting upward pressure on their stock price through their own persistent "bid." This tactic has been more prevalent among large companies than smaller ones, and provides a link to the unique interest-rate environment of the past several years.
But sometimes the easiest explanation is the correct one. The market is cyclical and, as we’ve demonstrated, the superiority of large-caps didn’t kick off until 2014. While it’s felt like a long time to us as we’ve suffered from performance envy, that’s not terribly long in terms of market cycles. In the latest parallel of the current market to that of the late-1990s, consider that from 1995-1999 the annualized return of the S&P 500 was 28.5% while the Russell 2000’s was 16.7%. That’s considerably more dramatic than what we’ve experienced since 2014 — or even the more dramatic version we’ve seen over the past 12 months. Sure enough, over the following five years the performance gap reversed with the S&P 500 suffering annualized losses of -2.33% from 2000-2004 while the Russell 2000 enjoyed annualized gains of +6.61.
As is often the case in investing, the point at which investors grow most eager to throw in the towel on a particular investing trend is normally the point when doing so would be the most damaging to their future returns. This is obvious in hindsight, as when we look back to that late-1990s period and clearly see that abandoning small stocks (or the "value" investing style) at that time would have been a terrible idea. But it’s never easy at the time, because it always feels as though the current trend might continue indefinitely.
For those who want to tilt their portfolios away from small stocks, it’s easy enough to do so by simply shifting a portion of the small-stock allocation in either JtB or Fund Upgrading to the large-stock categories. But having suffered through the underperformance side of the cycle, we’re not inclined to make that change at this point. Over the past 30 years, SMI has witnessed a lot of twists and turns in performance leadership and has found that most attempts to shift ahead of those changes aren’t productive. So we’ll stick with what has worked over the long haul, while continually exploring ways to improve our processes.
