U.S. large cap stocks have outperformed U.S. small cap stocks since 2013, putting us four years into a performance regime that typically lasts six years. The current wave of large cap outperformance appears to be past its halfway point, but we believe it has at least two more years to run. In our opinion, multiple forces support this continued outperformance. In particular, we’re focused on: (1) higher exposure to faster international growth and U.S. dollar (USD) weakness; (2) lower corporate tax rates; and (3) a flattening Treasury yield curve.
A Historical Perspective
U.S. large market capitalization stocks—as represented by the S&P 500 Index—enjoyed a five-year period of outperformance from 1994 to 1999. The longest economic expansion in U.S. history, coupled with investor fervor for new technologies, inflated the biggest U.S. large cap bubble on record. However, U.S. Federal Reserve (Fed) monetary policy tightening and an associated economic recession brought the dot com party to an end.
U.S. small cap equities—as measured by the Russell 2000 Index—followed up this period with an unprecedented wave of outperformance between 1999 and 2013, sparked by exceptionally cheap relative valuations and renewed investor interest for anything but big U.S. multinational corporations (MNCs).
After 15 years of unwinding past excesses—a process that deflated large caps to their lowest level relative to small caps since the 1980s—investors began rotating back into extremely undervalued large cap equities in 2013. While we anticipate that the tide will eventually turn back toward small cap stocks, the following factors support large cap outperformance for the next few years.
1. Large Caps Are More Internationally Oriented and Gain from USD Weakness
A weakening U.S. dollar and strengthening international economies are key reasons why we think U.S. investors should consider large cap stocks. Currency fluctuations have had clear implications for the size cycle during the last couple of years. For example, the S&P 500 has significantly outperformed the Russell 2000 alongside a weakening U.S. dollar in 2017. Why? U.S. dollar depreciation gives large U.S. MNCs a boost through foreign sales and exports, demand creation, positive accounting translation effects and increased competitiveness. Sub-par domestic economic outcomes and improving foreign prospects suggest U.S. investors should stay focused on the S&P 500.
Foreign sales are the fundamental connection between currency dynamics and the performance of the market capitalization strata. Geographic revenue analysis tells us that U.S. large cap companies have higher foreign exposure as 30% of S&P 500 revenues come from outside the United States. By contrast, U.S. small cap companies have higher domestic exposure as 80% of Russell 2000 revenues come from within the United States.
2. Large Cap Earnings Benefit from Lower Effective Corporate Tax Rates
Credits and incentives can make a big difference in how much a company pays in taxes by effectively lowering a firm’s taxable income. Qualifying for these tax breaks, however, often requires spending significant sums, making them unavailable to many small companies and startups. Bigger businesses can deduct greater expenses—including executive stock options, private jets, and corporate sponsorships—because they have the financial resources to do so. Basically, the more money a company makes, the better its effective tax rate.
Further, the U.S. Internal Revenue Service doesn’t tax income earned in foreign countries, many of which have lower corporate tax rates than the United States. As such, large MNCs can move substantial parts of their operations abroad, and pay much less in taxes than they would at home. Small companies and startups often don’t have the revenues to establish foreign operations, at least not on a scale great enough to make it worthwhile. Until U.S. political leaders level the financial playing field for small companies and startups, current tax law will continue to give large corporations a distinct advantage.
3. Tighter U.S. Monetary Policy and a Flatter Yield Curve Spurs Large Cap Leadership
The U.S. Treasury yield curve is one of the 10 leading economic indicators, and a direct relationship exists between the yield curve and the performance of the Russell 2000 relative to the S&P 500. A steepening curve today portends better times ahead and good news for higher-beta segments of the equity market. Conversely, a flattening curve now points to more challenging economic conditions down the road and bad news for economy-sensitive segments of the stock market.
When the Fed starts normalizing monetary policy, raising interest rates, flattening the curve, and discouraging risk taking—which is exactly what it’s doing—the mature, established companies in the U.S. equity universe tend to benefit. Historically, large caps have outperformed small caps by an average of 1.8% in flattening yield curve regimes. From that perspective, it’s no mystery why large caps are enjoying the rally that they are.
U.S. small cap stocks enjoy some advantages today, including easy credit conditions in the form of loose banking standards, solid investor risk appetite as expressed by narrow high yield corporate bond spreads, and low equity market volatility. These positive forces, however, are outweighed by the strength of the evidence favoring continued large cap outperformance for the foreseeable future. Read our accompanying white paper for more reasons why we think investors should continue to think big.
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