2021 has been an interesting year. Yes, the S&P 500 is having a stellar year, and on the surface, so too are other segments of the market. However, many areas of the market that have year-to-date gains accumulated all of those gains in the first three months of the year. Small cap stocks, for instance, as represented by the S&P 600 (ETF: IJR), are up about 17% on the year. But since peaking in mid-March, they are down 6%. Meanwhile, the S&P 500 (large cap stocks) has rallied 11% since the mid-March top for small-caps. This is a performance gap of 17%. In other words, after being an accelerator for portfolio growth in the first quarter, small cap stocks have since been a drag on performance.
Why own small cap stocks then?
Commonly, when we explain these findings we get a response of, well why own small cap stocks? If they’re not doing nearly as well as large cap stocks then shouldn’t we just own large cap stocks instead? This is a loaded question because it assumes that past performance is predictive of the future. (Remember: past performance is not an indicator of future results).
Small cap stocks might outperform large cap stocks for a time, like they did at the beginning of the year, only for that performance to switch in the opposite direction. Explaining that shift, let alone timing it on a consistent basis, is impossible. That’s why we believe in maintaining exposure to all areas of the market so that we benefit from its inherent randomness.
Market’s take turns moving higher
Because of that randomness, markets generally take turns moving higher. This is often referred to as “rotation,” or when money rotates from one area of the market to the other. 2021 has been a great example of rotation between small cap and large cap stocks. Take the two charts below, the first looks at a small cap ETF (IJR) and the second looks at a large cap ETF (VOO):
Small cap stocks had a big rally to start the year, but then topped in Mid-March and are down about 6% since.
Large-cap stocks went sideways to start the year but have rallied significantly ever since small-cap stocks peaked in mid-March.
If the market remains on steady ground, which we think it will, there is likely to be more rotation that takes place. Given that large-cap stocks have enjoyed a nice rally over the last 7 months while small cap stocks have rested, we’re wondering if we see the market rotate back in favor of small-cap stocks. Being aware of the various rotations taking place in the market can help frame portfolio performance in the proper context. If you’ve been frustrated with the performance of small-cap stocks recently, we don’t think now is the time to throw in the towel. If anything, it may be time to turn optimistic.
