If there was one strong consensus view coming into 2015, it was that the dollar would rise. In this instance, the collective wisdom was correct. The U.S. Dollar Index (DXY) is up roughly 10 percent year-to-date, according to Bloomberg data.
However, while the consensus was right on the direction of the dollar, it was wrong on at least one implication of a stronger greenback: small-cap outperformance.
The Large-Cap/Small Cap Dynamic
Many investors assumed that a strong dollar would provide more of headwind for large-cap companies, allowing small caps to outperform this year. But while large-cap earnings have been dented by the dollar’s strength, Bloomberg data show that the large-cap S&P 500 Index was outperforming the small-cap Russell 2000 by more than 300 basis points (bps) through late November.
What went wrong, and how should investors think about the small-cap tilt in 2016?
In terms of what went wrong, it was the value side of the equation. Since the start of the year, the trailing earnings multiple on the S&P 500 has nudged higher, advancing approximately 2.5 percent. In contrast, the price-to-earnings (P/E) on the Russell 2000 has contracted by around 2 percent.
The relative performance of small and large caps against financial market conditions helps to explain these shifting valuations.
While a stronger dollar provides less of a headwind for small-cap companies, the dollar has been strengthening in the context of pending Federal Reserve (Fed) tightening and less benign credit markets. The latter point is particularly important for small caps, which perform best when credit conditions are easing.