In our May 2018 Economics Weekly, we examined the debate over small cap versus large cap and concluded that given where we thought we were in the economic cycle (i.e., in the later stages), investors should tilt their portfolios toward the larger-cap stocks.
While individual stock performance is fairly idiosyncratic, the performance of various styles and sectors taken as a whole tends to strongly reflect changes in the business cycle. Small stocks, in particular, tend to be much more cyclical than larger stocks, given their activities are mainly domestic and do not benefit from as much international diversification. As such, they tend to perform relatively better early in the cycle when exiting a recession—when their increased sensitivity to the economy's credit impulse is felt more acutely than for the large caps, and underperform in the year or two before the cyclical peak—as interest rates start to increase, spare capacity starts to shrink, and they do not have the scale or diversity to sustain their returns.… We are nevertheless still in the late stage of the economic cycle. As such, investors should already be tilting toward the larger-cap end of their investment benchmark indices, where risk-adjusted returns will tend to be more favourable.
—Economics Weekly: The Late-Cycle Larger-Cap Bias (18 May 2018)
Even though we don't know the depth and duration of the current recession, there should be little doubt that we are actually in one. Thus, in this Economics Weekly we revisit the debate over small cap versus large cap, with the view that investors today should consider rotating their portfolios back toward smaller-cap stocks.
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Richard de Chazal, CFA is a London-based macroeconomist covering the U.S. economy and financial markets.