Get Ready For The Small Cap Cycle

By Haik Aram Kevorkian

Overconcentration within the S&P 500 has started to break down—and that’s when small caps have tended to shine.

After more than 12 long years, the stage may finally be set for an extended upswing in small-caps. While precisely timing the next cycle is impossible, we believe some key relative indicators are worth considering.

First, small-cap valuations relative to large-caps are touching historic lows. Current levels are similar to those observed in 1973 and 2000, which coincided with the starts of the past two small-cap cycles.

Second, we are also seeing a breakdown in the concentration of mega-cap leaders. The weight of the top five large-cap stocks peaked in 2020 and has been declining ever since. We saw similar peaks in 1973 and 2000, followed by declines.

When leadership concentration broke down in previous cycles, we saw multiyear periods where small caps outperformed large caps.

In 1973, the weight of the top five stocks in the S&P 500 index reached 24%; by 1994, it had dropped to 11%. But as large-cap concentration deteriorated, small-cap outperformance swelled: Between 1973 and 1985, small caps trounced large caps by a total of 220%.¹

The same pattern played out beginning in 2000. In that year, the largest five names accounted for 18% of the index before eventually declining, to 11%, by 2014. Meanwhile, small caps again outpaced their larger counterparts, by 67%, between 2000 and 2007.²

In the current cycle, top-five concentration peaked at 24% in 2020 and has now ebbed to 19%, though small caps have not yet begun to rally in earnest.³ Yet.

Taken on their own, relative valuation and large-cap concentration measures are no substitute for business-cycle indicators or fundamental earnings analysis when assessing potential value within an asset class. But if history is any guide, these signals might just be hinting that the next small-cap cycle isn’t too far away—if not already here.

Source: (1) Furey Research; (2) Ibid; (3) Furey Research

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