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What's Ahead for Small-Cap Stocks?

NYSE exchange floor
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NYSE exchange floor

Four years into the current bull, with sentiment waffling between skeptical and optimistic, it seems we're at least past the halfway point — typically large-cap stocks' time to shine. Yet, small-caps have had a nice run lately, prompting many investors to ask: Will this countertrend rally stay, or will big stocks soon regain leadership?

We expect the world's largest companies — mega-cap stocks — to perform better, on average, over the remainder of the bull market. In our opinion, this is largely tied to the yield curve and investor behavior in this maturing expansion.

You can thank the Federal Reserve for this. Typically, small firms perform best when the yield curve is steep and bank credit is, as a result, plentiful. Many small firms rely on bank lines of credit to finance new equipment, software, facilities, hiring, and the like, all of which supports growth.

However, the Fed's successive rounds of quantitative easing have flattened the yield curve, sapping banks' appetite for lending. The yield curve, the difference between long and short rates, represents a bank's potential profit on the next loan made (i.e., banks borrow short to lend long).

When the curve's flat, potential profits are small, and banks have less incentive to lend. Then, small firms —often viewed by banks as riskier investments — are often squeezed out of lending markets. That makes growth difficult, limiting shareholders' potential upside.

In addition, since late 2008 the Fed has been paying banks a competitive rate to park excess reserves, giving banks still less incentive to lend as aggressively. This likely impacts upon smaller firms disproportionately.

Large companies typically fare better relatively when the yield curve's flat. Not only do they frequently have a relatively easier time securing bank financing, but they can also more easily tap corporate debt markets, where interest rates are near generational lows.

It's a significant advantage for these larger firms in a maturing expansion, and the Fed has signaled QE won't end any time soon. Policymakers have pledged to stay "accommodative" until unemployment falls to 6.5 percent and inflation ticks up to 2.5 percent. With unemployment at 7.7 percent and improving slowly, monthly asset purchases of $85 billion seem set to continue indefinitely, keeping long rates down and the yield curve flat.

From a sentiment perspective, it seems to us mega-cap stocks are also likely to be in favor. With economic growth slowing some globally, many seasoned investors are eyeing the end of this expansion and looking for the companies they believe best able to hold up when the going gets tough — firms with strong brand names, strong balance sheets, globally diverse revenue streams, and less volatile earnings growth.

These are hallmarks of the world's biggest firms. The bigger the company, the more quality investors perceive. Small-caps, by contrast, tend to be in favor earlier in an expansion, when investors are willing or even eager to make more cyclical bets.

Newly optimistic investors should give large stocks an additional boost. Many retail investors who've been in cash for much of this bull market are only now warming to stocks. Perhaps they're just now realizing the S&P 500 has more than doubled (on a total return basis) since the March 9, 2009, low, and they're finally comfortable wading back in.

But these investors — naturally more skittish — typically don't jump into smaller firms, where they perceive more risk. Instead, they go for the names they're most familiar with, the world's biggest companies. Or, they buy broad equity index funds or mutual funds, which tend to skew big. Either way, they tend to bid up the biggest firms whose market cap exceeds the market's weighted average: mega-caps.

So while small-caps have enjoyed a decent run in recent years, looking ahead we expect larger firms to outrun all other categories. We may see the odd counter-trend — like markets overall, sectors, countries, and styles never move in a straight line — but in our view, over time and on average, mega-cap firms appear much better positioned to outperform in the period ahead than small firms.

By TheStreet.com Contributor Fisher Investments

Additional News: Mid-Cap & Small-Cap Catch-Up Plays

Additional Views: Large-Cap & Small-Cap Picks That Offer More Than Size

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