Why are large cap companies outperforming small cap companies in the US since late 2018?

 

S&P 500 and Russell 2000 index

Source: Investing.com

 

S&P 500 and Russell 2000 each represent stock performance of large cap and small cap companies in the US stock markets. Although overall trend shows similar movements, S&P 500 Index has started to outperform Russell 2000 Index since early 2019. As of August 2020, S&P 500 is outperforming Russell 2000 index by approximately 20%. What would have caused the difference?

 

  1. Emerging markets growth

 

One potential theory is that economic growth from developing countries has not translated into rise in stock price in emerging markets.

 

Why? Because investors had refrained from investing in emerging markets’ equity due to various factors, such as political instability, low transparency and high trading costs involved in buying equity in emerging market. This is evident in the chart below, in which the MSCI Emerging Markets Index has stayed roughly the same since 2010 while the economies of emerging countries grew annually at 5% on average from 2010 to 2019.

 

MSCI Emerging Markets Index

Source: Investing.com

 

Multinational corporations based in the US, such as Apple and Facebook, have reaped the benefit of economic growth in emerging markets, as they also have large presence in those markets. Most of the US companies which had branches in emerging markets were mostly large cap companies, which benefited from rise in the US stock markets.

 

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  1. Cash to withstand the crisis

 

Recent COVID-19 pandemic has resulted in sharp equity sell-off. However the degree of sell-off has been more pronounced in small cap equities, and the subsequent recovery in stock market also shows that small cap equities lag behind large cap equities.

 

This is most likely due to the fact that large companies have either large pile of cash or access to cash to withstand economic impact, whereas small companies do not have such capability. Thus, investors are investing in large cap companies as they see them less risky in this volatile macro environment.

 

Such divergence only started a few year ago. Will emerging markets economic growth translate into equity growth in their stock markets, eventually? If so, then it may be a good idea to start looking for investment opportunities in emerging countries’ stock market.

 

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