There’s No Small-Cap Market

One of the misunderstood points of financial markets is that Affect A is very often the outgrowth of Effect B.

A good example is volatility. Commentators often discuss volatility as if it’s an entity above and apart from the market, but that’s not really the case. In reality, movements in the VIX are strongly correlated to what the market recently did. I once found a 70% correlation between the VIX and the distance the S&P 500 is from its six-month high. Markets don’t rise because volatility is low. Instead, volatility falls because the market is up.

Another example is gold. It’s not some mystery risk quotient. Rather, movements in gold are strongly tied to movements in real interest rates. Sure, there’s some noise mixed in, but once you clear things off, that’s what’s really going on.

Today I want to turn my sights to the small-cap market. There’s a great deal of literature about the “small cap premium.” Frankly, I’m pretty skeptical that it truly exists. Even if it does, it appears to be quite small and highly volatile. The data shows that small-caps have underperformed for several years at a time.

Likewise, movements in the Russell 2000 aren’t anything magical. The Russell 2000 is largely the S&P 500 just without utility stocks. Check out this chart. It’s the Russell 2000 divided by the S&P 500 (blue line) compared with the Utility ETF divided by the S&P 500 (black line).

Over five years, and they’re like mirror images.

My point is that for me to be convinced that there’s truly a small-cap premium, I would need to see a comparison of similar companies in similar industries with similar balance sheets and similar risk profiles. Obviously that can’t literally be done, but in a theoretical exercise, once everything is corrected for, I doubt there’s much of a small-cap premium.

Posted by on April 13th, 2017 at 11:39 am

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