Large vs Small Caps: Fundamentals vs Risk

One of the asset allocation decisions we research is whether to favor large-caps or small-caps within an equity portfolio. Currently, we see a stark divergence in the broad categories of indicators: the fundamentals of earnings estimates and valuations are now more favorable for small-caps, while low risk appetite among investors and later cycle economic conditions have been favoring large-caps.

Large-cap estimate revisions holding up much better than small-caps

Our indicators of analyst earnings estimates revisions in the US highlight a key theme: revisions for large-cap (and mid-cap) stocks have held up much better recently than those of small-cap stocks.

While the proportion of analysts raising their earnings estimates relative to those cutting estimates has been declining ever since its extremely high peak in the middle of last year, the difference between large-cap and small-cap revisions has favored large-caps, and has shifted further in favor of large-caps most recently.

Stay with large-caps as volatility picks up

In our view, equity markets have been shifting toward a backdrop of higher volatility and thus more modest gains relative to the last 18 months. After an all-time high in early January, the S&P 500 recently endured its first 10% decline since September 2020 before rebounding sharply in recent days. This pickup in volatility is consistent with the pullback in fiscal and monetary stimulus, and the natural development of the economic cycle. Bonds are still unattractive on a relative valuation basis compared to stocks, but market and macro conditions are no longer as lopsidedly in favor of stocks as they have been.

Relative volatility risk in US small-caps remains high

Among the various asset allocation decisions for which we provide guidance to clients is whether to favor small-caps or large-caps (i.e., the “size” factor) within the US equity market. In our view, small-caps do not reliably outperform large-caps consistently over time (as some models and studies might suggest), and instead view the “size premium” (outperformance of small-caps) more as a cyclical phenomenon that tends to show up under certain macroeconomic and market conditions.