James W. Paulsen, Ph.D.

Perspective

Economic and Market

February 19, 2015

Bringing you national and global economic trends for more than 30 years

Time for Small-Cap Stocks?

Small-capitalization stocks underperformed significantly
in 2014 and relative to their larger brethren, the S&P 500
Index, have only managed to be market performers since
early 2010. Understandably, many investors have recently
become frustrated moving portfolio allocations away
from small company stocks.
For several reasons, however, 2015 may prove to be a
good year for small-cap stocks. First, in 2014, net flows
into small-cap EFT funds trailed large-cap flows by the
largest margin of any year since at least 2000! Indeed,
small-cap fund flows have been paltry in the last few
years leaving many investors significantly underexposed
to small-cap stocks. Second, the relative price/earnings
(P/E) multiple (based on future one-year mean earnings
estimates) for small-cap stocks is now lower than at any
other time in this bull market and has declined to slightly
below average since 1995. Third, historically, small-cap
stocks have done poorly during periods of disinflation
and much better during years of re-inflation. We expect the deflation scare of 2014 to give way to a global
economic bounce this year which should be much more
hospitable for small company stocks. Finally, although
small-cap stocks have struggled during years when the
Fed first initiates tightening, their recent underperformance suggests they may do well despite the Fed beginning to normalize interest rates.

Pessimistic sentiment favors small-cap stocks

As shown in Chart 1, since early 2011, the relative

performance of small-cap stocks has been volatile and
disappointing. Both in 2011 and again last year, small-cap
stocks underperformed significantly. Chart 2 illustrates
how this difficult period of performance has shaped investor sentiment. It shows net fund flows into large-capitalization ETFs less fund flows into small-cap ETFs. Fund
flows tend to follow performance and reflect investor
expectations or sentiment toward an asset class.
Not only did small-cap fund flows trail large-cap flows
in 2014 by the largest amount since at least 2000, but
fund flows have been noticeably biased toward large-cap
stocks for the last four years! This reflects diminishing
expectations surrounding small-cap stocks and bearish sentiment which has increased the likelihood of a
positive surprise. More importantly, after several years

of disappointment, many investors are now probably underexposed to this asset class and would need to boost
allocations should performance improve.
Chart 1: Relative small-cap stock price performance
Russell 2000 Stock Price Index relative to S&P 500 Stock Price Index

Chart 2: Net new cash flows into U.S. ETFs

Large-cap ETF flows less small-cap ETF flows
Annually, in billions of U.S. dollars

Economic and Market Perspective

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Small-cap valuations have improved

Small caps need a little inflation

Chart 3: Relative price/earnings multiple

S&P Small Cap 600 Index divided by S&P Large Cap
500 Index

Chart 4: Small-cap versus large-cap relative total

return performance and consumer price inflation

As Chart 3 illustrates, relative small-cap valuations have been

abnormally high throughout this recovery. Based on consensus
estimated one-year forward earnings per share, the relative
P/E multiple among small-cap stocks declined significantly
since 2013, is now slightly below its average since 1995 and is
essentially where it was in the early 2000s. The improvement
in relative valuation may simply amplify how much investor
sentiment surrounding small-cap stocks has worsened in
recent years and improved valuation is not necessarily a good
timing indicator. However, the much improved relative P/E
multiple does suggest the potential for solid excess returns
from small-cap investments has been restored!

Price to consensus estimated one-year forward earnings per share

Note: Dotted line represents the average P/E multiple since 1995.

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As illustrated in Chart 4, small-cap stocks have typically

outpaced large caps during periods of rising inflation and
have tended to underperform when disinflation rules. Since
1925, the best small-cap eras have been during WWII (i.e.,
the re-inflation after the Great Depression), the chronic U.S.
inflationary spiral between the late 1960s and the early 1980s,
and finally, the emerging world led commodity boom between
2000 and 2008. Conversely, the worst historical periods for
small-cap stocks were during the Great Depression, the
disinflationary era after WWII (i.e., 1950 to about 1965), and
during the great disinflationary era the U.S. has experienced
since 1980.

Left scaleSmall-cap versus large-cap relative total return, log scale

(solid)
Right scaleThree-year average annualized CPI inflation rate
(dotted)
Note: Small-cap and large-cap monthly return data is from Ibbotson
through 12/31/1978. Small-cap data is Russell 2000 Index since 1978.

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While the relationship between small-cap relative performance and the inflation rate has not been perfect, it has
been a reasonably close and consistent affiliation for several
decades. It certainly explains why small caps underperformed
in 2011 and 2012 when most expected an imminent breakup in the eurozone would send the global economy into a
tailspin or last year when the collapse in oil prices escalated
deflationary spiral fears. Moreover, as shown in Chart 5, it
is probably no coincidence that directionally the relative
performance of U.S. small-cap stocks has been similar to the
relative performance of emerging market stocks since 2000.
Both do best with some inflationary undertow (i.e., rising
commodity prices between 2001 and 2008 and again from
early 2009 until late 2010) and suffer when world trends turn
deflationary (e.g., increasingly since 2011).
Chart 5: U.S. small caps versus emerging market stocks
relative (to S&P 500) Price Index
Left scaleSmall cap (Russell 2000 Index) price performance (versus
S&P 500) (solid)
Right scaleMSCI Emerging Markets Index relative price
performance (to S&P 500 Index) (dotted)

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We believe the relative performance of small-cap stocks

is dependent upon underlying inflation conditions because
changes in inflation impact large and small companies quite
differently. As shown in Chart 6, large companies always
operate with wider profit margins. They tend to be more
established and therefore often have fluff whereas small companies typically run much leaner and meaner. Consequently,
during disinflationary times, when top-line pricing becomes
more competitive, large companies with wider margins have
far more flexibility to absorb weakening or falling sales prices.
By contrast, small companies, with narrow margins which
traditionally operate near the edge, have far less ability to
successfully navigate a period of weak sales pricing.
Chart 6: S&P 600 (small cap) and S&P 500 (large cap) Index
operating margins
S&P 600 small cap operating margin (solid)
S&P 500 large cap operating margin (dotted)

Economic and Market Perspective

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Essentially, small companies with tight profit margins, have

greater operating leverage compared to larger companies.
This is illustrated in Chart 7 which overlays the relative
profit margin of small-cap companies with the annual rate of
consumer price inflation. Although an imperfect relationship,
relative small company profit margins are certainly impacted
by the direction of inflation. When inflation accelerates and
selling prices can be raised, a larger portion of the enhanced
selling price falls to the bottom line of narrow margin smallcap companies. That is, rising inflation tends to boost both
profit margins and earnings performance among small companies relative to their larger brethren.
Chart 7: Small-cap/large-cap operating margin ratio versus
core consumer price inflation rate
Left scaleRatio of S&P 600 operating margin divided by S&P 500
operating margin (solid)
Right scaleAnnual core consumer price inflation index (dotted)

WELLS CAPITAL MANAGEMENT

Clearly, as shown in Chart 4, the prolonged disinflationary

era since 1980 has been challenging for small companies.
Small-cap stocks have outpaced on a sustained basis only
two times in the last 34 years! During the early 1990s (after
consumer inflation accelerated during the late 1980s), and
again during the early 2000s (when the emerging world
caused commodity prices to surge). Therefore, while smallcap stocks may currently be reasonably priced and investor
sentiment is constructive, U.S. inflation probably needs to lift
before small-cap stocks will again lead the stock market.
Many expect deflationary concerns to remain dominant this
year. However, we suspect U.S. core consumer price inflation,
wages, and commodity prices are set to rise in 2015 helping to boost the relative performance of small-cap stocks.
Last year was the first time in this recovery when economic
policy was synchronized across the globe. Every economy
was treated last year to a massive fiscal tax cut (in the form
of a collapse in energy costs) and the equivalent of a massive
quantitative easing program (i.e., an extensive drop in sovereign bond yields about the globe). This synchronized global
economic stimulus is likely to lead to a synchronized global
economic bounce. For many foreign economies (e.g., Japan
and the eurozone), a bounce in economic growth will not likely prove inflationary but would tend to reduce if not eliminate
deflationary fears. However, in the U.S., which is nearing full
employment, a further bounce in economic growth will likely
raise inflation indicators, inflationary concerns, and anxieties
surrounding the Federal Reserve. That is, if real GDP growth
stays north of 3% this year and the unemployment rate heads
below 5%, inflationary evidence should mount paving the way
for renewed leadership among small-cap stocks.

Economic and Market Perspective

5

Could the Fed abort a small-cap revival?

Conventional wisdom advises against new commitments to

small-cap stocks when the Federal Reserve is about to begin
raising interest rates. However, as Chart 8 shows, when the
Fed has initiated a tightening cycle, the impact on small-cap
leadership has been mixed.
The solid dots in Chart 8 signify when the Fed first began
raising the funds rate during each recovery since 1970. Smallcap stocks did poorly once the Fed began raising interest
rates in the first 1970s recovery, the 1980s recovery, and the
1990s recovery. Conversely, small-cap stocks continued to
outpace after the Fed initiated tightening cycles during the
late 1970s recovery, in the brief 1980 recovery, and in the
early 2000s recovery.
Chart 8: Small-cap versus large-cap stocksRelative total
return index versus Fed initial recovery rate hikes

WELLS CAPITAL MANAGEMENT

While Fed tightening could hurt small-cap stocks, there is

no consistent historic precedent suggesting this is a bad part
of the recovery cycle to add small-cap stocks. Moreover, as
shown in Chart 8, Fed tightenings which ultimately hurt relative performance have generally followed a period of smallcap outperformance. For example, small-cap stocks outpaced
prior to the early 1970s initial Fed tightening and significantly
outperformed prior to initial Fed tightenings in both the
1980s and 1990s recoveries. Since small caps outperformed
prior to these Fed tightening cycles, they were probably
extended once the Fed finally began to raise interest rates.
By contrast, today, small-cap stocks have underperformed significantly in the last year, are under-owned, and have recently
undergone a significant improvement in relative valuation.
Consequently, small-cap stocks appear much less vulnerable
to Fed rate hikes today compared to past recovery cycles.

Economic and Market Perspective

6

SummaryGo small in the U.S.

At the beginning of this year, two consensus views were

predominant. The U.S. was the place to be invested and large
U.S. blue chip stocks was the play. We think both popular
views will prove disappointing this year. U.S. stock returns
are already trailing international markets and a few significant
factors suggest small-cap stocks may soon gain leadership.
First, investors are pessimistic about and under-allocated toward small-cap stocks. Small caps underperformed large caps
by a wide margin in 2014 and have been mostly disappointing
for the last several years. In recent years, net new flows into
large-cap ETFs have far outpaced new flows into small-cap
ETFs. Not only does this reflect investor pessimism (often
evidence of poor sentiment toward an asset class is a good
sign it is near a bottom) but also suggests most investors are
now under-invested in small caps.

Second, for the first time in this recovery, the relative P/E multiple (based on future one-year average earnings estimates)
for small-cap stocks recently declined below its 20-year average! Indeed, based on this valuation metric, small-cap stocks
are no more expensive today than they were in the early
2000s or in the mid-1990s!
Finally, small-cap stocks traditionally perform poorly when
inflation declines (or when deflation fears emerge as they did
in 2014). However, we expect a synchronized global economic
bounce this year and for U.S. inflation indicators to rise mildly.
This should help improve small company operating leverage
and help small-cap stocks regain leadership.
Investors should consider augmenting exposure to an asset
class which is currently under-owned and significantly out
of favor, which has recently declined to its cheapest relative
valuation of the recovery and which is likely to soon begin
enjoying a much more hospitable economic environment (i.e.,
re-inflation).

Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides
investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change.
This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation
for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness
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possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or
refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT is a registered service mark
of Wells Capital Management, Inc.
Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2015 Wells Capital Management