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After a massive period of large cap outperformance, we just had one of the biggest short-term rotations towards small cap outperformance since 1999. Maybe it will be transient and the ratio will resume its downward trend, but this is certainly something to watch.

Lyn Alden

Every decade or two, markets tend to have big rotations of performance.

In other words, there are large structural cycles where large stocks outperform small stocks, US stocks outperform international stocks, or growth stocks outperform value stocks, or vice versa for all of those comparisons.

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Ever since the vaccine announcements began coming in early this month, the markets have been showing signs of a potential rotation. Over the past decade, large growth-oriented U.S. stocks have outperformed many other indices, but have become quite expensive relative to earnings.

This chart shows the Russell 2000 (which represents small stocks) divided by the S&P 500 (which represents large stocks). Whenever the line is going up, it means small stocks are outperforming, and whenever the line is going down, it means large stocks are outperforming.

Chart Source: YCharts

After a massive period of large cap outperformance, we just had one of the biggest short-term rotations towards small cap outperformance since 1999.

Maybe it will be transient and the ratio will resume its downward trend, but this is certainly something to watch. It could very well turn into the next cycle of smaller-cap outperformance.

Even if we look globally at large and medium-size companies, the median stock in the index is showing signs of life against the broader index (which is strongly weighted towards the mega-cap growth stocks with the largest market capitalizations). The green line in this next chart shows the percentage of stocks in the MSCI World Index that are outperforming the broad index year-over-year:

Chart Source: Julien Bittel, Pictet Asset Management

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Within the past 25 years, only in 1999, 2008, and 2020 have there been periods where the index outperformed nearly 70% of stocks in the index, only for that trend to begin to reverse. These all represented major performance rotation periods for markets.

In 1999, there was a big rotation from large cap U.S. growth stocks to US value stocks, US small stocks, and foreign stocks. After large US tech stocks dominated global returns in the 1990’s, small, value, and foreign equities took the lead in the 2000’s.

In 2008, there was a big rotation from foreign stocks, value stocks, and small stocks back to large U.S. growth stocks. The 2010’s decade was indeed dominated by the “FAANG” collection of mega-cap U.S. tech stocks.

At this point in 2020, many of those large tech stocks are very expensive relative to earnings, and some of these underperforming sectors are starting to becoming interesting again.

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Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.

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