Over the past year, large cap stocks have vastly outperformed their small cap counterparts. This widening rift between the biggest and smallest public companies has reached extremes not seen in over 20 years. While large caps continue charging ahead, small caps face mounting challenges that threaten their role in a balanced investment portfolio.
The stark contrast is evident in the returns of two major indices. The S&P 500, comprised of 500 of the largest U.S. companies, has delivered over -15% returns over the past 12 months. Meanwhile the Russell 2000 small cap index plunged over -25% over the same period.
This nearly 10 percentage point gap represents the highest divergence between large and small caps since 2001. The lopsided returns conjure memories of the late 1990s dot-com bubble, when mega cap tech stocks left smaller companies in the dust.
However, the current environment contains even stronger headwinds against small caps. Rampant inflation has battered small companies, which lack the pricing power of large cap brands. Ongoing supply chain difficulties and labor shortages have also taken a heavier toll on small business.
Moreover, the Federal Reserve’s aggressive interest rate hikes to combat inflation have disproportionately impacted small caps. Not only are borrowing costs up, but higher rates dampen economic growth forecasts which small caps rely upon. With the Fed signaling even more hikes ahead, the path ahead looks rocky.
Large caps have also benefitted from a flight to quality. Investors have piled into mega cap stocks like Apple, Microsoft, and Procter & Gamble as safe havens amid volatile markets. These stalwarts deliver steady revenues and dividends that provide shelter from broader economic storms.
The growth versus value dynamic has also disadvantaged small caps. With recession fears looming, investors have favored large cap stocks of mature companies over risky, high-growth small caps. Additionally, large tech names like Amazon and Nvidia dominate future-facing themes like cloud computing, AI, and the metaverse.
Some analysts argue this gap has created a bubble, with popular large caps trading at overextended valuations. However, until inflation shows meaningful declines, small caps will likely continue struggling against their mega cap peers.
For investors, the uneven returns underscore the importance of diversification between company sizes. While small caps carry higher risks today, they historically deliver long-term outperformance. Once the economy stabilizes, the pendulum could swing back in favor of smaller dynamos. For those with the risk tolerance, small caps trading at multi-year discounts could offer an opportunity.
Looking ahead, economic uncertainty persists. But maintaining exposure across the market cap spectrum remains imperative. Having allocation to both large and small caps allows investors to weather various market cycles. With patience and prudence, this lopsided period will eventually balance out.