Is the Historic Small-Cap Cycle Coming to an End?

    Is there life still left in the currently aging cycle of outperformance for small-cap stocks, already one of the longest on record?

    An analysis by T. Rowe Price sheds some light on the relative behavior.

    Small- and mid-cap stocks have significantly outperformed larger companies since early 1999, far surpassing the historical average of about five years for a typical “small-cap cycle.”

    From the end of 1998 through 2006, the Russell 2000 index of smaller companies had an annualized return of 9.5%, compared with 3.4% for the Standard & Poor’s 500 index.

    Last year, small-cap stocks soared until the spring correction when they fell more sharply than the market, trailed in the third quarter, but showed unexpected resilience in the fourth quarter. Figure 1 shows the relative performance of small-cap versus large-cap stocks since 1960.

    Two Phases

    The analysis notes that this cycle has had two phases.

    In the first phase, from 1999 to 2002, small caps were recovering from an extended period of underperformance in the 1990s when large-cap growth stocks did extremely well, and small-company relative valuations hit all-time lows.

    The second half of the cycle was economically driven, coming out of the 2001 recession, when small-cap stocks typically do well.

    This long period of outperformance has led to concerns about the relative valuations of small-cap stocks, with the relative price-earnings ratio of small-cap stocks at the high end of its historical band.

    In addition, the relative earnings growth of smaller companies, while quite strong, has unexpectedly lagged large-cap earnings growth over the last five years. Typically, small-cap earnings grow faster than those of large-cap stocks coming out of recessions.

    Figure 1.
    Small-Cap Stocks
    vs. Large-Cap Stocks
    (Total Returns)*

    Liquidity a Driver

    Investors’ appetite for riskier asset classes the past couple of years appears to have helped extend small-cap leadership and could continue to work in its favor, according to the T. Rowe Price analysis. Another factor for propelling this cycle beyond expectations identified by the analysis has been the vigorous pace of merger-and-acquisition activity. The number of takeovers has reduced the number of small-cap stocks quite measurably at a time when IPO (initial public offering) activity has been more muted. Merger-and-acquisition activity is in an uptrend, and at levels higher than anytime in history except for the 1999 bubble.

    Part of this merger-and-acquisition activity has been driven by a record amount of money going into private-equity funds, which has led to a record amount of leveraged buyout activity involving smaller companies. That may put more of a floor on valuations and relative stock performance, and is likely to make small-cap stocks hold up better than they might otherwise over the next few years, according to the analysis.

    The analysis notes, however, that supply/demand and liquidity issues can influence the level of stock prices in the short run, but in the long run fundamentals and valuations win out, with small-cap fundamentals and valuations currently at the high end of their likely trading range. The T. Rowe Price analysis does not foresee a significant downside tosmall-cap stocks at the current time, but concludes that the best days of the small-cap cycle are probably behind us.

    This article is based on an analysis that originally apeared in the Winter 2007 issue of the T. Rowe Price Report.