The S&P 500 (SNPINDEX:^GSPC) has set several all-time record highs so far in 2014, with positive performance even as the Dow has struggled with modest losses. Yet the Russell 2000 (RUSSELLINDICES: ^RUT) has continued to outshine the large-cap benchmark this year, extending its long-term domination throughout the five-year-old bull market. What's behind small caps crushing the S&P, and what will it take for large-cap stocks to catch up to their smaller counterparts?
The harder they fall, the higher they rise
During the 2008 recession and financial crisis, the entire stock market sold off. But as you'd expect, many small-cap stocks got hammered much harder than large-cap stocks, because in many cases, their entire survival was threatened.
As a result, when the market recovered beginning in 2009, the fact that those small-caps had in fact survived the crisis led to some truly amazing returns. Over the past five years, the S&P 500 has averaged an impressive 19.4% annual return -- but the small-cap Russell 2000 has beaten even that impressive figure by five full percentage points.
Surprisingly, though, that trend has continued long after the initial recovery phase. Over the past year, the Russell 2000 is up 26%, compared to just 19% for the S&P 500. Indeed, even small-cap mutual fund managers can't believe the good fortune that the Russell 2000 has had lately, as more than two-thirds of fund managers underperformed the small-cap index last year, and 87% have underperformed over the past three years. That's a big vote of confidence for ETFs iShares Russell 2000 (NYSEMKT:IWM) and SPDR S&P 600 SmallCap (NYSEMKT:SLY), which seek to match popular small-cap benchmarks rather than beat them through active management.
Time to switch gears?
As a result of the long outperformance of small-cap stocks, many stock experts are starting to look at large-caps as being relatively undervalued. Joel Greenblatt, for instance, who uses his Magic Formula Investing method to pick promising stock prospects, recently said that large-cap stocks have valuations that are only mildly above their typical levels. But in contrast, he noted that small-caps have only been more expensive about 5% of the time, and he argued that the best place to invest was in the biggest of the large-cap stocks, whose valuations are actually fairly reasonable.
Still, it's no easier to try to time when large-cap stocks will start to outperform small-caps than it is to time the market on the whole. If earnings start to drop, perhaps as a result of less access to the capital markets for small companies, then small-caps could fall further than their large-cap counterparts.
The best solution is to keep both large-cap and small-cap exposure in your portfolio, all the while making sure that you keep your portfolio and risk level in balance. Rebalancing to avoid overweighting either sub-asset class makes the most sense, especially if you believe that large caps will eventually return to their outperforming ways. In the meantime, though, you don't want to make a huge bet only to have small-caps continue beating their bigger counterparts for years more to come.