Nasdaq 100’s rally leaves the Russell 2000 trailing behind

Everyone loves small caps or is supposed to. Small cap companies are viewed as the engine of the economy, being nimbler and more creative than their lumbering big-cap cousins. And they have compelling growth stories, finding oil in tough places and creating brilliant new products that revolutionise the world.

The problem is that while they might do all of these things, the performance of small cap companies overall does not live up to expectations. There will be the great success stories, like Salesforce, which went from being a $2 billion market cap company in 2005 to the $244 billion titan of 2020. But for every huge winner there will be dozens of failures, companies that ultimately went nowhere, or plenty of moderately successful firms that were acquired by those ponderous large-cap firms that do not have the exciting stories of their smaller brethren.

This is why the Russell 2000 has been such a miserable performer compared to other indices, and especially against the unstoppable Nasdaq 100. Over the last five years, the Russell 2000 is up 37%, versus 186% for the tech index. The S&P 500 is up 81% over the same time frame.

The problem with small cap indices is that, by and large, the successful companies in that index either get taken over or become large cap companies, like Salesforce, which was promoted to the Dow this week, perhaps the ultimate recognition of its success and its importance to the US economy. The rest are left behind.

So why do investors like to focus on small caps? They are much more exciting, often seeing bigger swings in their stock prices. And they have great stories, that are so much more interesting to write about compared to McDonald’s continuing to sell hamburgers by the million, or Amazon slowly becoming the go-to online retailer for a hefty chunk of the world’s population.

But small caps are usually higher concentrated companies, without the diverse revenue streams of big corporations. This gives their bigger brethren a predictability that makes them more attractive for investor. A diversified miner can weather a downturn in one area or metal, but a small miner with only a couple of locations will be highly exposed to swings in ta particular metal or political developments in a country.

You often see headlines that talk about small caps being a good indicator of market strength. A rally in the minnows suggests investors are willing to take on more risk. But this often happens before a major pullback, as sentiment becomes too bullish and markets correct. Most of the time small caps tend to lag, and that’s no bad thing for the majority of investors, who will in any case probably only have a small allocation to small cap stocks.

Perhaps there is a degree of attraction to small caps precisely because they have not rallied as much as the Nasdaq. Human psychology looks at a chart of the two and think that small caps should start to play catch-up. But stock markets do not work that way. Winners tend to keep winning, and big stocks tend to keep getting bigger. Yes, the Nasdaq has gone up by a huge amount, but the top of the chart is not a ceiling (and if it looks a little too parabolic, try using a logarithmic chart and see how that changes your view). Indices are usually powered by just a small fraction of their constituents, and for the Russell 2000 the problem is compounded by the factors I mentioned above.

In bull markets, it makes sense to buy the strongest stocks, sectors and indices, and then sell the weakest in bear markets. While the Nasdaq and S&P 500 push into new record territory, the Russell 2000 is still 8% off its highs. Chances are that, by the time it gets to a new record, the bigger indices will be even higher.