Large caps and small caps

There is a school of thought, which Macro Man admits to finding rather compelling, that the current economic environment is almost uniquely suited to the outperformance of large capitalization stocks over their smaller capitalizaton counterparts.....particularly in the US.

As American domestic demand slows, the best-placed firms will be those that can shift sales focus to higher-growing areas of the globe. These would tend to be large-capitalization multinationals.

Globalization and all that it brings would appear to favour companies that can take advantage of low-cost production opportunities in emerging economies, as well as the tax arbitrages offered by certain countries. These would tend to be large-capitalization multinationals.

Abundant global liqiuidity over the past few years has created huge pools of capital- including private equity and soverign wealth funds- in search of investments. These institutions, running tens if not hundreds of billions of dollars, are unsurprisingly looking at publicly listed equities as a source of return. Of course, for an investment to be economically viable, these funds need to be able to deploy billions of dollars in each transaction. By definition, that would appear to favour large caps.

Of course, there is a price for everything, and this year has seen large caps outperform small caps by a large margin. To proxy this, Macro Man looks at the relative price of the OEX (i.e., the S&P 100) versus the Russell 2000. Over the last six months, the OEX has outperformed the Russell 2000 by more than 8%. It looks like the factors listed above have already been priced in.....
....or have they? Sure, the OEX has outperformed this year, but that follows on the heels six years of pretty stunning small cap outperformance. Indeed, the relative price ratio of the two indices is near the lowest level since Macro Man's price data goes back (to the end of 1978.) The OEX outperformance shown above, when seen on a long-term chart, appears to be little more than the initial stages of a meaningful bottom and trend reversal.

Of course, there's no guarantee that trends in the relative prices of these indices are reflective of "fundamentals." Sometimes popular themes take on a life of their own and continue to persist even after the fundamental rationale for the trend has evaporated, if indeed it ever existed in the first place. To perform a "sense check" that large cap/small cap relative performance is driven by the sorts of things that Macro Man is looking at, he performed a simple study. Using the profits data from the national income and product accounts of the US, Macro Man looked at relative growth of foreign- and domstically-generated profits. If his thesis is to hold water, Macro Man will want to see large caps outperform when foreign profit growth outstrips domestic profit growth, and small caps outperform when the inverse is true.

In fact, there does appear to be a relationship between profit source growth and performance by market cap. The fit is far from perfect, and the correlation between the two series is only 0.32. The fit beween relative performance and foreign profits as a percentage of the total is actually a bit better, with a correlation of 0.37. Where the profit indicator missed a beat was the onset of the last bear market, when domestic profits collapsed and took overvalued large caps with them. However, the indicator suggests that much of the outperformance of small caps in recent years has been justified, with smoothed foreign profit growth only recently accelerating above the rate seen domestically. If Macro Man is correct, this should augur further large cap outperformance.

But can this trade actually be done as suggested here? Nothing could be easier. Both the OEX and the Russell 2000 are replicated via ETFs, both of which have market caps in the billions of dollars. As the chart below indicates, the relative prices of the OEX ETF (OEF) and the Russell 2000 ETF (IWM) are indistinguishable over meaninfgul periods of time from the cash indices.

So now, we have a trade. If Macro Man's view is right, the OEX/R2k relative price could easily go back above 1 from its current level of 0.88. The 0.80 level shouldn't really be seen unless circumstances change. While it is true that there is no particular reason why the relative price series should mean-revert (indeed, economic theory suggests that it should trend lower to compensate investors for the extra risk that they bear for owning small caps), it is also true that this trade should benefit from selection bias. After all, small cap companies that become phenomenally successful, eventually grow to the point where they are no longer small caps....they become large caps.

While Macro Man has had problems with equity spread trades in the past, the volatility of the returns should be easier to bear now that he has a much more diversified portfolio. He will therefore buy 138,000 shares of OEF and sell 121,300 shares of IWM, which works out to about $10 million/leg. He targets at least 1 on the price ratio, and will review at 0.80.

Elsewhere, the low to date in EUR/USD has been 1.4139. So close, but yet so far....