The new year has doled out misery among large and small-cap stocks alike. The iShares Russell 1000 Index ETF (NYSE:IWB), which aims to replicate the performance of the Russell 1000 (large-cap) stock index, was down 6.3% as of the market close January 28 while its small-cap counterpart, the iShares Russell 2000 Index (NYSE:IWM) was down 7.0%.

Don't bet on those two names sticking close to each other for the rest of the year, however. After a long cycle of underperformance the sun may shine on large caps again in 2008. (For related reading, check out The Ups And Downs Of Investing In Cyclical Stocks.)

Today's Darling, Tomorrow's Dog
Style investors point to evidence that at any given time there are styles that are in and out of favor. Since June 2000 the large-cap ETF (IWB) was nearly flat (-1.1%) through December 31, 2007 while the price of its small cap cousin (IWM) was up a healthy 38% for the same period.

I see five distinct performance cycles for cap styles over the period from 1979 to 2004. The table below shows the total, time-weighted average annual returns of the Russell 1000 and the Russell 2000 stock indexes for this 25-year period.

Please note that indexes themselves are not directly investable. ETFs, index funds and other vehicles seek to replicate the indexes for investment purposes.

- 1979-83 1984-90 1991-93 1994-98 1999-2004
Russell 1000 (index) 17.6% 13.75% 16.91% 23.37% 1.70%
Russell 2000 (index) 26.7% 4.59% 27.17% 11.87% 8.92%
Large vs. Small Differential (9.1)% 9.16% (10.26)% 11.5% (7.22)%
Length of Cycle 5 years 7 years 3 years 5 years 6 years
Source: Zephyr & Associates LLC

Interestingly, for this entire 25-year period there was only one calendar year in which the out-of-favor cap style outperformed the other: in 1988, amid a seven-year large-cap cycle, the Russell 2000 returned more than the Russell 1000 (24.9% vs. 17.2%).

Where are we now?
Large caps outperformed in 2005 and 2007 while small caps won in 2006. Below are total return data below for both the indexes and the ETFs (note that ETF performance reflects applicable fees)

- 2005 2006 2007 Total
Period
Large
Caps
Russell 1000 (Index) 6.27% 15.46% 5.77% 9.08%
Russell 1000 (IWB) 6.15% 15.29% 5.68% 8.95%
Small
Caps
Russell 2000 (Index) 4.55% 18.37% -1.57% 6.80%
Russell 2000 (IWM) 4.46% 18.17% -1.47% 6.74%
Source: Zephyr & Associates LLC

A large performance gap in 2007 indicates we may be in the early stages of another large-cap cycle. Of course, with style investing as with any other strategy, it is important to remember that past performance may not be a reliable indicator of future returns.

Cap Cycles and the Broader Market
Do large caps or small caps perform better in a particular broader market context? Good question. Mixed answer.

I looked at total calendar-year returns for the Dow Wilshire 5000, a broad all-cap index of U.S. stocks. For six of the years from 1979-2007, the performance was negative. In 1981, a recession year, small caps outperformed. Large caps did better in 1990, amid widespread fears of a credit crunch, and in 1994, when the Fed raised its Fed funds rate target by 2.5%. Small caps were stronger in the dismal 2000-2002 period.

There were also six years when the Dow Wilshire 5000 returned over 30%. Small caps prevailed half the time (1980, 1991 and 2003) while large caps did better the other half (1985, 1995 and 1997). In short, the cycles seem to run their course irrespective of good times or bad.

Conclusions
Why cap stocks move in cycles is a question open for much debate, however they have indeed exhibited cyclical behavior over a long time period. The recent trend has been towards large caps after a long run by small caps earlier in this decade. Given the rewards cap style positions have yielded during previous cycles, this may be a good time to consider a large-cap play.

For related reading, check out Determining What Market Cap Suits Your Style.

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