We noted last month that the performance reversal between small caps and large caps in early September brought the two benchmarks to a pivotal point at the upper bound of the trend line that was established in mid-2018. While small caps teased a breakout, the top line of the channel proved to be a point of resistance for small caps once again as they quickly gave up all of their gains and are testing recent lows.

Absent a return to early-cycle macroeconomic dynamics, we continue to find it challenging to make a case for sustainable outperformance for small caps relative to large caps and expect large caps to post their third year of relative outperformance in 2019, which has not occurred since the late 1990s.

What We’ve Seen

Over the last year, large caps have outperformed small caps by over 11% and are approaching the greatest difference seen between the two all year as the market continues to favor large caps. Equal weighted versions of both indexes show even greater return gaps, highlighting investor preference for larger firms is pervasive across and within cap ranges.

In the most recent BofAML Global Fund Manager Survey, 40% of participants noted that they expect to see large caps outperform small caps over the next 12 months, which was down 2% from September but remains one of the higher conviction points of relative positioning. The respondents also favor companies that have high quality earnings versus those with lower quality earnings, and expect higher dividend yielders to outperform those with lower dividend yields. While all three are distinct positioning opportunities for investors, their risk factor exposures are highly similar in this environment.

Small Caps Have Lagged Large Caps Over The Last Year

Source: FTSE Russell, as of October 15, 2019. Data displays the total returns of Small Cap defined as the Russell 2000 Index and Large Cap defined as the Russell 1000 Index. Past performance is not indicative of future results. One cannot invest directly in an index.

Money In Motion

Outside of survey data, investors are putting their money where their mouth is when it comes to ETF allocations over the last two years as illustrated by quarterly net flows. Other than the sizable outflows driven by the volatility spike in the first quarter of 2018, large caps have seen the lion’s share of flows.

Halfway through October, investors reversed course and sold out both cap ranges, suggesting a bit of risk-off mentality in recent months. While the flows out of large caps are greater in magnitude, they are modest compared to the third quarter’s inflows and the market size.

Flows Continue To Favor Large Caps

Source: Bloomberg Finance, L.P., as of October 1, 2018 to October 15, 2019. Data represents the monthly net flows of U.S.-listed U.S. Large Cap ETFs and U.S. Small Cap ETFs, specifically targeting exposure to U.S. Large Cap and U.S. Small Cap stocks, respectively.

What’s Next?

While we believe that large caps will remain in the driver’s seat thanks to the continued uncertain economic environment that has seen increased growth deceleration as of late, one cannot ignore that the relative valuations for small caps are increasingly attractive as the multiples for large-cap firms have increased sharply this year, while small caps have not.

In order to better understand the valuation opportunity, below is the percentile ranked standardized valuations of large caps relative to small caps on a monthly basis starting with the earliest available clean data in March 1995. Without even diving into the data, it is clear that large caps trended higher over recent years as one may expect with price to sales and price to book rankings approaching multiples not seen since the TMT bubble, but still remain below those extremes for the time being. It is notable as price to earnings is not showing anywhere near the levels that the other two metrics are, which may be even more compelling for large caps considering that earnings are generally a poor metric to use for small cap companies.

As all investors learn, sometimes painfully, valuation alone is not a catalyst for outperformance, especially as small-cap earnings are expected to be significantly worse than large caps in the third and fourth quarter of 2019. While we watch closely for cues towards forward guidance and top and bottom line growth in both market-cap segments, we anticipate that market participants will likely continue to favor the higher quality reflected in large-cap names.

Valuations Favor Small Cap, But They Have Been More Stretched In The Past

Source: Bloomberg Finance, L.P. as of September 30, 2019. Data displays the percentile rank of the standardized valuations of Small Cap defined as the Russell 2000 Index and Large Cap defined as the Russell 1000 Index. Past performance is not indicative of future results. One cannot invest directly in an index.

— David Mazza is managing director and head of product at ETF provider Direxion.