There are several interpretations for this phenomenon. Small-cap firms are more of a credit risk, so the availability and ease of financing is more critical for these companies. Another mechanism is market sentiment. Small caps are generally considered more speculative. In an environment in which credit conditions are easing, volatility is typically lower and investors are more willing to embrace risk.

History supports this thesis, according to an analysis using data accessible via Bloomberg. Looking back over the past fifteen years, in months when high yield credit spreads were widening, indicating tighter financial conditions and more risk aversion, the S&P 500 outperformed the Russell 2000 by an average of roughly 0.45 percent.

However, when financial conditions were easing, indicated by tighter credit spreads, the Russell 2000 outperformed by roughly 1 percent a month. This dynamic was supportive of small-cap performance for most of the period from the spring of 2012 through early 2014. Then, as credit conditions started to turn last spring, the environment became less favorable for small caps. Since last July, small caps have underperformed large caps by around 50 bps a month, Bloomberg data show.

The key lesson is to watch not only earnings, but also what investors are willing to pay for those earnings. While I don’t expect a significant deterioration in credit markets next year, conditions are turning less favorable: corporate leverage is higher, default rates are rising and with oil hovering near $40, energy issuers are at risk. If spreads do continue to widen in 2016, there’s a case for again tilting toward the safety of larger firms.

 

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.