Historically, market capitalization, the value of all outstanding shares of a corporation, has an inverse relationship with both risk and return. Corporations with larger market capitalizations, at $10 billion and greater, tend to grow more slowly, on average, than mid caps between $2 and $10 billion and small caps between $250 million and $2 billion. Large caps tend to be less volatile during rough markets as investors fly to quality and become more risk-averse. This was on full display in 2015; large caps performed much better than their smaller counterparts, and much of the same could be on deck for 2016.
Markets are understandably cautious, even nervous, heading into 2016, as 2015 marked the 10th consecutive year in which real GDP failed to hit 3% in the United States, a record-long stretch of economic stagnation for the 239-year-old nation. The Federal Reserve raised its target interest rates in December 2015 for the first time in seven years. Global markets are wobbly after struggles in the Eurozone and China, propped up only by ultra-low oil prices. Investors may be unwilling to gamble on smaller and less-proven companies.
Even though expectations are modest, there are always some winners in the stock market. Long-term value investors may be able to find deals in the small- and mid-market spaces, but expect a flight to larger and safer investments if volatility emerges as 2016's theme.
A Quick Look Back at Small, Mid, and Large Caps in 2015
After raucous growth for equities in nearly every category throughout 2013 and 2014, most stocks struggled to find any traction in 2015. According to data from JPMorgan, value stocks of every size were down for the year, highlighted by a -7.5% average for small-cap value stocks. Growth stocks outperformed their blend and value peers in every segment, with large-cap growth stocks climbing 5.7% during the year.
The S&P 500 was down slightly in 2015, declining less than 1%, although a deeper look shows it was not even that strong. In fact, if you take away four of the largest public companies in the U.S.—Amazon, Microsoft, Facebook and Alphabet (formerly Google)—the S&P 500 would have lost more than 4%.
Weakness in the equities markets was driven by softness in commodities, particularly petroleum, and emerging market bets. Energy stocks dipped 21% on the whole, but large-cap consumer discretionary stocks jumped more than 10%.
Among the major Russell indexes, the Russell 1000 Growth, for large caps, won the year with 5.67% growth; the Russell 2000 Growth, for small and mid caps, lost 1.38%; the Russell MidCap lost 2.44%; and the Russell 3000, for small caps, lost 8.78%. Across the board, larger stocks performed better; the gap between the Russell Top 50 Mega Cap Index, where mega caps refer to companies valued at more than $200 billion, and the Russell 3000, which includes 98% of the entire U.S. public market, hit a 10-year high in 2015.
Small-Cap Stocks in 2016
Lack of liquidity remains a struggle for small caps, especially for investors who take pride in building their portfolios on diversification. Between 2006 and 2015, approximately $6 billion in shares traded on the Russell 2000 compared to greater than $35 billion for the S&P 500 over the same period. This has two effects: small-cap investors may struggle to offload shares, and the managers of small-cap funds close their funds at lower assets under management (AUM) thresholds.
Volatility struck small and mid caps in January 2016, although this is not a new phenomenon. There could be opportunities for value investors to jump in on oversold small-cap companies in the late first quarter or early second quarter of 2016, especially if the Fed raises interest rates again. Between 1980 and 2015, small caps averaged 11.24% annual growth in the face of rising rates, easily outpacing mid caps at 8.59% and large caps at 8.00%. If the economy improves and interest rates creep near 1% by 2017, small caps could rule the next decade.
Mid-Cap Stocks in 2016
Since 2000, no equity segment has performed better than mid-cap value stocks. The same story holds true for mutual funds, despite serious struggles for value investors in 2015. Mid-cap value plays through 2013 to 2015 tilted heavily toward consumer goods, industrials and financials. The struggles of the U.S. industrial sector are well documented, and financial stocks normally perform worse in rising rate environments. For these reasons, it seems unlikely mid caps will post strong numbers in 2016.
As recently as 2013, the Russell MidCap Index and the Morningstar Mid Cap Index grew nearly 35%. The momentum crashed after materials and energy companies fell by more than half between Q2 2014 and Q2 2015. Mid-cap stocks, especially mid-cap values, tend to carry less liquidity and experience more volatility than large caps. Fundamentals should continue to inform value, and since many mid caps expanded on the back of cheap debt, companies without relatively large cash pools and room to borrow may struggle to find momentum. Unless future prospects solidify, expect a tepid year for the segment.
Large-Cap Stocks in 2016
Despite its struggles, the S&P 500 entered 2016 just 4% shy of its all-time high. Large-cap stocks still had stable price-to-earnings (P/E) ratios; positive earnings growth, albeit clumped around mega caps; and dividend yields that historically correlate with 6% to 9% returns. There are reasons to be optimistic when it comes to large caps.
It would actually be more precise to say that there are reasons to be optimistic with large caps relative to other domestic stock sizes. Small caps and mid caps ruled the four-year period between 2011 and 2014, but increased regulations and earnings weaknesses among smaller companies all point to large-cap leadership in 2016. Additionally, large caps tend to operate with more market efficiency than smaller segments; there is a decided advantage for large caps in terms of liquidity and research coverage.
What is perhaps most encouraging is the fact that large technology companies cemented their status as valuation and earnings champions, even as domestic markets plodded. As investors look for comfort and quality in 2016, expect large caps to receive an even larger share of attention than normal.