Small Cap Is No Canary

Whenever a correction strikes markets—one of those sharp, sudden, sentiment-fueled drops of -10% to -20%—there are a few things you can bank on happening. Often there will be a big story. Headlines will probably argue the market is right to be down (which generally won’t happen early in a bear market). And you will find articles looking for hidden clues worse things are in store. We have seen that third one a lot over the past week or so, with a growing belief small-cap stocks’ larger decline implies they know something the larger-cap S&P 500 doesn’t. But a quick tour through market history shows small-cap underperformance during a downturn isn’t a magic indicator.

Definitions of small and large cap vary. We have found, over the years, that companies whose market cap is much below the broad market’s weighted-average market cap tend to perform like small cap, while those around or above it tend to best represent large cap. But after long periods of large cap outperformance, that universe tends to be vanishingly small. So for quick-and-dirty analysis of longer-term trends, we are happy to go with the flow and let the Russell 2000 represent small cap and the S&P 500 represent large cap.

When we do so, we find small cap’s recent decline is bigger and longer than the S&P 500’s. Where the S&P 500 just barely crossed -10% from its high on February 19, small cap’s high was back in late November.^[i] Its largest drawdown, thus far, was a shade over -18%.^[ii] Headlines claim this is a bad sign, a canary in the coal mine for big cap. Evidence these stocks are pricing in some broadly unseen recession risk because small caps are more economically sensitive.

It is fair enough to note that small companies tend to be more cyclical and rely more on bank lending, so they are more vulnerable to the economy’s ups and downs. Many lack the economies of scale, robust balance sheets and qualitative features that cushion larger companies to an extent. And small caps did peak before the S&P 500 in the bear markets that began in 2000 and 2007.

Problem is, small cap has also behaved this way during plenty of past corrections. It started sliding before the S&P 500 during the corrections in 2012 and 2018, for example.^[iii] And it performed worse than the S&P 500 during almost every single correction since the financial crisis’s end: 2010’s, 2011’s, 2012’s, 2015 – 2016, Q4 2018’s and even July to October 2023’s.^[iv] The Russell 2000 had a correction in 2014. The S&P 500 moved concurrently but never reached the -10% mark. Ditto for late 2012. Pretty much the only correction in which the S&P 500 fell more in this span? Q1 2018’s minor correction. And that was one percentage point.^[v]

So simply noting small cap doing even worse than large caps doesn’t tell you anything about whether a given downturn is a correction or bear market. It isn’t even interesting information couched this way. It is the norm. Yes, for the most part the two move concurrently, differing in magnitude rather than direction, but the exceptions aren’t unique to bear markets. Therefore, we can’t look at small caps’ three-month head start and conclude markets are pricing in a recession and stocks overall must have more to drop.

When confronted with widely held beliefs like those about small cap today, one helpful trick is to flip the narrative. If small cap started falling in late November while the S&P 500 rose through mid-February, that means large cap had a rally small cap didn’t participate in. What does that coincide with? The S&P 500’s post-election rally. Which all kind of makes sense, when you consider how hard sentiment swung after November’s contest, when many investors believed the incoming administration’s policies would favor larger companies in Tech, defense and basically anything with a big global reach that would benefit from tax cuts. So large cap’s sentiment bump dwarfed small cap’, which was small and a quick round trip. We wouldn’t read any more into it than that.

Since the S&P 500’s high, it and small cap have been much closer in magnitude. We wouldn’t read into that, either, beyond noting that it cuts against the claims that small caps are doing markedly worse now. Sentiment seems to be overemphasizing volatility that happened in December. That is backward-looking. And very correction-like. In a true bear market, it is highly likely that the vast majority of pundits would be calling this a buying opportunity.

None of this tells us when the correction will end or whether or how much further it has to fall. There is no magic 8 ball or crystal ball for this. No category of stocks is all-seeing while others are blind. The investors are going to have a lot of overlap. All anyone can do is assess conditions and see how sentiment and reality square. To us, sentiment seems too dour. The post-election enthusiasm is gone, replaced by tariff and DOGE dread, with a side of recession fear. All the eyeballs on small cap are evidence of that. These are all correction hallmarks, with the fears reminiscent of classic correction fears and therefore bricks in a bull market’s wall of worry. This suggests strongly to us that patience and discipline remain correct.