Each year the market behaves in a way that makes certain sectors of the economy outperform more than others. While the natural flow of the business cycle is always in motion, other factors influence subsets such as small-cap companies and large-cap companies.
Capitalization is simply the size of a company. Small-cap generally refers to companies with a market capitalization between $300 million and $2 billion, while large-cap companies refer to companies with market caps of $10 billion or more. Certain aspects of the economy can spell good news for either large-cap or small-cap stocks, and each year there’s a clear winner. For 2015, small-cap stocks began the year ahead of their larger counterparts but then fell in the latter half of the year, never really recovering. This made it a good year for large-caps rather than small-caps.
David Versus Goliath
Positive economic data is good for stocks of all sizes. As the saying goes, “A rising tide lifts all ships.” But beyond that, there are factors that specifically help out small-cap companies and are detrimental to large-caps and vice versa.
Let’s start off with the strength of the U.S. dollar. A high local currency means that imported goods are cheaper and exported goods become more expensive for buyers. That means that manufacturers or retailers that do business overseas will experience a tougher environment than companies that only operate in the U.S. – especially if they import goods from overseas as well. That’s good news for smaller companies since they generally have little to no international business dealings.
Foreign exchange risk is the other side of the same coin. International trade means currency exchange losses can occur when the currency is converted to U.S. dollars. Again, bad for large stocks and good for small ones.
If we look at last year though, we can clearly see how a strong dollar dominated all of 2015. So it would stand to reason that small-cap stocks would’ve outperformed – yet this is not the case.
The reason large-cap stocks did well last year has to do with several factors. One was a preference for risk. As the economic data began to look more and more unconvincing, investors sought the protection of larger, more stable companies.
The other reason is the Federal Reserve. It’s still unclear exactly how the rate hike (or rate hikes) are going to impact financial markets and whether it will be good or bad news for small-cap stocks. The extended environment of low energy prices and low interest rates has been a boon for all companies with the exception of energy stocks. Until further data is received, investors still aren’t sure if that’s been more beneficial for small-caps or large-caps.
The Bottom Line
Coming into 2016, we should expect to see a bit of a repeat performance from last year, with small-cap stocks taking an early lead as investors have historically been more amenable to risk at the beginning of the year. However, unless there’s a significant change in the global economy, large-cap stocks should ultimately catch up and outperform again this year as volatility stays high and uncertainty continues to grip the markets. Furthermore, the U.S. dollar will almost certainly be challenged this year as commodities that have been trading at unnaturally low prices look to rebound somewhat. Either way, it’s looking like another year for the large-caps thanks to their high stability, dividends, and conservative investment style.