Both Small-Cap and Large-Cap Stocks Rebound Strongly

Last weekend, a friend of mine expressed concern about his adviser’s desire to maintain an allocation to small-cap stocks. My friend cited the performance of the large-cap S&P 500 index relative to small-cap stocks as the reason for not needing small-cap exposure. I responded by explaining that a period of 10 to 12 years is too short make a judgment.

As irony would have it, a couple of days later, I received commentary arguing in favor of small-cap stocks from Gregg Fisher of Quent Capital. Fisher essentially described the outperformance of large-cap stocks relative to small-cap stocks over the past 11 years as being unusual. He further said the ending of low interest rates removes a catalyst that previously supported high valuations for high-growth stocks.

Who is right? Well, the data supports having an allocation to both large-cap and small-cap stocks—including now, even though we remain in the midst of a bear market.

My buddy was correct in saying large-company stocks have outperformed in more recent times. During the 10-year period ending December 2022, large-cap stocks returned a sizzling 16.1% on an annualized basis versus a still impressive 14.9% for small-company stocks. To have enjoyed these great returns, investors would have had to stay consistently allocated to stocks—a point that is too often overlooked.

Over the long term, the returns are still very good. Between 1946 and 2022, large-company stocks realized an annualized return of 10.9% according to data from the Ibbotson “Stocks, Bonds, Bills, and Inflation” 2023 Yearbook. Small-company stocks gained a more impressive 12.4%. While very few have 77-year-old portfolios, these annualized gains show that stocks have gained despite wars, recessions, financial crises, a pandemic and all sorts of political drama.

Resiliency is another a very big reason for staying allocated to stocks. Fisher also cited this as a reason in making the case for small-cap stocks. Since World War II, down years for small-company stocks were followed by gains nearly three-quarters of the time (73%). The average return during those rebound years was 34.7%; the median return was 25.2%.

What about large-company stocks? I’m glad you asked because the numbers—to paraphrase comedian Larry David—are pretty, pretty good. Large-company stocks rebounded 69% of the time following a down year. The average rebound during those up calendar years that followed a down year was 27.8%; the median return was 27.6%.

I know you’re probably thinking: “Whoa! Those are big numbers!” It’s easy to forget how much upside volatility the stock market can have when we’re mired in a bear market.

Some of you are probably taking the opposite stance and want to know what happened during those preceding bad years. The losses are smaller than you might expect. Since World War II, the average calendar-year loss for small-company stocks has been 12.4%. The median loss has been 10.4%. Large-company stocks have fared slightly better on this metric, with an average calendar-year loss of 11.7% and a median loss of 8.9%. (These numbers exclude 2022. With 2022 included, the average losses are 12.1% and 12.4% for large-cap and small-cap stocks, respectively.)

If those losses are smaller than you expected, there are two things to keep in mind. First, bear markets are not confined to calendar years. Large-company stocks ended 2007 up 5% even though the financial crisis started and worsened during the year’s second half. Second, though long and severe bear markets stand out in memory, large-company stocks have only experienced back-to-back down calendar years twice since World War II (1973–1974 and 2000–2022). Small-company stocks have only done so three times (1969–1970, 1973–1974 and 2007–2008).

Looking at market history helps to establish expectations for what could happen in the future. While history never guarantees what will happen—there is always the risk of a few big things going wrong, or right—it is frequently a better gauge to rely on than the shorter-term themes and forecasts made by so-called soothsayers who rely on their cracked crystal balls.