The gains that the Dow Jones Industrials (DJINDICES: ^DJI ) achieved in 2013 definitely impressed investors, with a 26.5% jump in the average marking its best year since 1995. Yet that strong return looks a lot less impressive when you compare it to the performance of smaller stocks in the market. As measured by the SPDR S&P MidCap 400 ETF (NYSEMKT: MDY ) , mid-cap stocks soared 33% in 2013, and the iShares Russell 2000 ETF (NYSEMKT: IWM ) weighed in with an even better 39% jump. Those results have investors asking one simple question: Can the Dow finally catch up with smaller stocks in 2014?
Smaller companies, faster growth
Historically, small-cap stocks have tended to outperform their larger counterparts over the long run. There's an intuitively obvious reason why: Small stocks have a lot more growth potential left in their shares than large companies, and so the best performers among small-caps will almost always have far better raw returns than top large-cap stocks. For instance, in 2013, Boeing led the Dow's gainers with a total return of 85%. Yet when you look at the members of the Russell 2000, fully 330 of the stocks in the index -- almost one-sixth of the Russell 2000 -- posted total returns of at least 85% last year. The top performer in the Russell, Gray Television, soared 576%, and it was just one of a dozen stocks whose shares jumped 400% or more in 2013.
The question going forward, though, is whether changes in macroeconomic conditions and monetary policy will shift the balance back toward large-cap stocks like the Dow's 30 components. The Russell 2000 and the S&P MidCap 400 fell more than the Dow did between the beginning of 2008 and the market's low in March 2009, as more small-cap stocks came closer to outright failure under the challenging conditions of the financial crisis than large-cap stalwarts. As a result, small-cap stocks were in a better position to post stronger gains in climbing back from those losses when the bull market began.
One point in favor of larger stocks is that investors have much higher expectations of growth from small-cap stocks than from Dow components right now. When you assess forward earnings multiples, the Russell 2000 weighs in at almost 30, compared to slightly more than 15 for the Dow. If the economy keeps growing and small-cap growth keeps outpacing that of larger companies, that pricing disparity might persist and still give small-cap stocks the edge. But if the economy starts to slow down, small-caps will likely take a disproportionate hit because of the higher growth projections that are built into their current share prices.
Take the balanced approach
With the bull market about to turn 5 years old, a change in market direction could give the more conservative Dow a better chance of outperforming smaller stocks for a change in 2014. Nevertheless, trying to time the market's behavior when it comes to large-cap versus small-cap stock performance is ultimately a difficult task. The simpler approach is to have a diversified portfolio that includes exposure to both large and small companies through exchange-traded funds like those listed above. That lets you take advantage of the best of both worlds as long as the bull market keeps lifting all stocks together.
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