Why? A couple of reasons. Following the collapse of the technology bubble, large cap volatility (i.e. price fluctuation) was much higher than their counterparts. As such small caps held up far better during a correction. They were also the first stocks to benefit from highly accommodating monetary policy and consequent explosion in world liquidity. In addition a number of large caps suffered so badly that by 2002 they became small caps themselves. However what’s more interesting are the resurgence of ‘new’ economy stocks and the importance of industry which have contributed the bulk of the new recent out- performance.
So what now? Nervousness has definitely increased since the October correction. Although government intervention has not really worked the situation appears to be slightly changing. What does government intervention do? Constrain liquidity which in other words controls inflation. Consequently the combination of monetary tightening and yield curve steepening could dampen consumption worldwide and therefore start to weigh on small caps, which depend heavily on economic activity.
This is already happening in our back yard! UK small caps are lagging the euro zone. The Bank of England was the first to start raising interest rates, and this caused household consumption to slow sharply. Small caps are much more dependent on national economic conditions than larger firms.
With all the doom and gloom the downturn is not upon us just yet, however , and by virtue of their great homogeneity small caps will always include stocks with far more upside than the large cap segment. What this all means is that stock-picking within small caps will increasingly important as monetary conditions become less favourable.
These views are independent of FactSet Ltd and are proprietary to Bobby Rakhit. For the full report and individual sector reviews and recommendations please contact rakhitreport@yahoo.co.uk.