Small cap stocks are having a stellar year with the Russell 2000 Index up nearly 20% year-to-date. In November, small caps outperformed large caps, as measured by the S&P 500, by roughly 9%, the strongest monthly performance in more than 15 years (source: Bloomberg data, as of 11/28/2016). What’s behind the rally — and more importantly, can it continue?
Many have pointed to the strong U.S. dollar to explain the small cap outperformance. The argument is a strong dollar supports America’s purchasing power, which helps smaller, domestically-focused companies while hurting larger, more export-oriented firms. This explanation has intuitive appeal, but it ignores two issues.
HISTORICALLY WEAK RELATIONSHIP BETWEEN THE DOLLAR AND SMALL CAP RELATIVE PERFORMANCE
Since 2000 the relative performance of small caps versus large caps has actually had a low correlation with changes in the dollar. While the correlation was negative at one point, it has historically been weak, explaining less than 1% of monthly relative returns. In short, although commentators have attributed small caps’ outperformance to a rallying dollar, history suggests otherwise.
SURGE IN RISK APPETITE
It is important to note that risky assets in general, not just small caps, have had a brilliant run. That reflects the change in sentiment we have seen. In fact, risk appetite, as measured by monthly changes in credit spreads, has had a much stronger correlation with the small cap relative performance than the dollar’s strength. Since 2000, monthly changes in high yield spreads have explained roughly 10%-15% of small caps’ relative performance.