Small capitalization stocks (small caps or small companies) have outperformed both mid caps and large caps since the late 1990's when large caps got grossly over-heated. If we look at the ratios of the SP Small Caps Index (SML) to Large Caps (SPX), Mid Caps (MID) to SPX, and SML to MID, we can see the progression out of the bloated SPX of the late 1990's and 2000. (Click on the thumbnail images for a full-sized image.)
What we see in 2005 is that small caps are beginning to lose strength to the mid caps, although both are still outperforming the SPX large caps.
While this may seem arcane, it tells us something about market dynamics at a time when the FED is increasing short interest rates and when the US Treasury yield curve is flattening.
Once again my favorite portfolio economists at Hussman Funds have an analysis on this very issue from 2003.
William Hester wrote a brief and crystal clear account of the diagnostics of portfolio rotation amongst small and larger caps against the background of a flattening or inverting yield curve such as
we are now seeing. As Hester puts it: "... for a sign that conditions for small companies might be weakening, keep your eye on the bond market."
In 2003 the yield curve wasn't flattening, but it certainly is flattening in the past year as the FED raises the short end and the bond rate has fallen at the long end--the famous "conundrum" of Greenspan.
As corporate profit growth begins to slow, small caps feel it first and large caps later. This was certainly the case in the later 1990's and may be starting again.
Hester writes, "As profits slow, value stocks lose their edge. In this environment, mid-sized and large growth stocks have done best, rising 18.5 percent and 16.5 percent, respectively, with small value stocks gaining 15.8 percent ......"
We care for two reasons. One reason is that we may need to adjust or re-balance our own portfolios toward the larger caps and away from the smaller caps. This needn't be an all-or-none switch but a weeding or re-balancing.
The second reason is that the yield curve and the cap rotation may both be hinting of an economic slowdown in the future, and both do so predictively. See Hester's "The Yield Curve - A Multi-Talented Indicator" for further details. http://www.hussman.net/popup/yldcurv.htm
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