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Large Caps vs Small Caps and Future Expectations


Hmm, the makings of a spread trade?


Several arguments have been made on the site lately regarding the potential future returns of large-cap stocks versus small-caps. They are all compelling, and I highly suggest everyone read the thoughts posted by Bernie, Succo, Scott Reamer and Kevin Depew in relation to the risks inherent in big-cap stocks now.

I tend to take a shorter-term view, and I want to point out something that has struck me lately regarding one aspect of the large-cap / small-cap debate.

The chart below compares the total dollar amount of assets in the Rydex Small Cap Growth and Small Cap Value funds to the amount of assets in the Large Cap Growth and Large Cap Value funds. The dark blue dotted line on the chart is the amount of assets in the small cap funds over and above the amount in the large cap funds. In other words, the higher the dotted line, the more traders are favoring the small-cap funds, and vice versa.

The light blue shaded area on the chart is the future 21-day excess return of the Russell 2000 versus the DJIA. The higher the shaded area, the more small-cap stocks outperformed large-cap stocks over the next month.

The relationship is pretty clear - the more money Rydex traders stuffed into small-cap stocks, the worse those stocks performed going forward (compared to large-caps). The correlation between the two is significant given the number of data points we have.

To be a bit more specific, when assets in the small-cap funds were below that of the large-cap funds, then the future 21-day return in the Russell 2000 was +2.3% greater than the return in the DJIA, with 86% of the days showing a positive bias towards the Russell 2000.

In contrast, when assets in the small-cap fund were at least $100 million greater than that in the large-cap funds (which is the case now), then the future return in the Russell 2000 was 0.4% below than of the DJIA, and only 27% of the days showed a positive bias towards the Russell 2000.

The bottom line is that in the short-term, traders who tend to be wrong on market direction at the extremes have greatly favored small-cap stocks over their bigger brethren, and the past couple years of history shows that such a situation has lead to better returns in the big boys than the small-caps.

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No positions in stocks mentioned.

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