Sector Performance During Past Shifts From Large Cap to Small Cap Equities
Recently we discussed the “rotation trade” and examined the performance of the S&P 500 sectors during shifts from growth to value. Another facet of the rotation trade has been a shift from large cap to small. Today we wanted to examine sector performance in another facet of this rotation – a shift from large cap to small cap. The relative sector performance between a small cap vs a large cap regime may seem less important than between value and growth as stocks in a given sector often fall in the same style category. While there are numerous large and small cap names in every sector, a shift from large caps to small caps is a risk-on trade and thus we would expect to find a performance bias toward certain sectors as well. It is also worth noting that while large and small cap stocks incorporate all of the 11 macro sectors, there are material weighting differences between the S&P 500 SPX and Russell 2000 RUT. For example, technology is the largest sector in the S&P 500, making up more than 25% of the index, and it accounts for under 14% of the Russell 2000, making it the fifth-largest sector in the index after health care, financials, industrials, and consumer discretionary.
We used a similar methodology for examining the sector performance during a shift from large cap to small cap as we did in last week’s piece which analyzed rotations from growth to value. We began by taking the spread between the rolling six-month total return of the iShares S&P 500 ETF SPY and the iShares Russell 2000 ETF IWM since 2000. Each time the spread peaked at 10% or more in favor of small cap, we looked back to a recent trough (i.e. when the spread was in favor of growth) and calculated the returns for the 11 macro sectors over that period. For example, we can see that around October 2003, the spread peaked at around 22% in favor of small cap, so looking back we find it hit a trough (i.e. the relationship most favored growth) in October 2002, when the spread was around -10%. We then calculated the returns of the S&P 600 SmallCap Sector Indexes for the interim period. The periods we examined are shaded in gray in the chart below; the line is red represents periods when the spread is greater than zero (i.e. small cap outperformed), and blue represents periods when the spread is less than zero. As you can see in the graph above, the spread fell to more than -17% in April of this year, the lowest value (i.e. most in favor of large cap) during our study period. Since then, small cap has gained ground and this month reached +15% for the first time since 2010. Historically, the relationship has not often gotten much above this level (the highest level in our study period was +22% in 2003) before there is some mean reversion in the relative performance. However, this is coming off of the lowest spread in the last 20 years, so perhaps small cap still has a bit more room to run.
During these periods of outperformance for small caps, the energy sector produced the highest average total return with a gain of 40.67%, followed by the materials sector at 36.25%. The worst-performing sectors during periods of transition were communication services and utilities, however, both sectors still managed average gains of 2.05% and 10.54%, respectively. Generally, traditionally "defensive" sectors, like utilities, health care, and consumer staples fell in the middle-to-the-bottom of the pack in favor of more "offensive" or cyclical sectors. Consumer discretionary produced the best single-period return of 94% (this year) while the communication services sector saw the worst single-period return of -51% in late-2000 to early-2001 amidst the "tech crash". When compared to the Russell 2000 benchmark - communication services, consumer staples, utilities, health care, and technology all underperformed. However, relative to the S&P 500 (SPX), all small cap sectors outperformed except for communication services, highlighting broad participation during transition periods and perhaps the long-term size-bias toward small cap as demonstrated by academic researchers like Fama & French.
In addition to the average total returns discussed above, we computed annualized figures to compensate for the varying length of examination periods. The shortest period observed was just 172 days, starting from the end of 2010 and ending in early 2011, while the longest period in our study was 343 days in 2002 – 2003. Like the average total return figures, the energy sector claimed the highest average annualized return and the communication services sector saw the lowest.
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