Megacaps dominated the past decade–here’s why the next one might look different.
KEY TAKEAWAYS
Small caps historically outperformed large caps
Recent underperformance tied to leverage and interest rates
Russell 2000 just hit all-time highs quietly
Futures imply more rate cuts coming–there may be implications for the Russell
Lower rates benefit small caps disproportionately
MY HOT TAKES
Investors remain overly anchored to megacaps
The leverage gap explains most of the past decade
Small caps are pricing a regime shift before the data confirms it
Ignoring small caps now would be lazy portfolio construction
Rate cuts could spark a multi-year rotation into smaller names
You can quote me: “The last decade belonged to the megacaps. The next one doesn’t have to.”
David and Goliath. Let’s try an exercise. Ready? Really quickly name the first stock that pops into your head? Don’t think–just blurt. What was it? Was it Apple, NVIDIA, or Exxon Mobile? Tesla or, perhaps, Amazon? Do you own any of these? Probably. How about Plug Power, Rocket Lab, or IonQ? These probably don’t ring a bell. Those last three were widely held small cap stocks, and the first names–the ones you most likely have on your brain are large caps–some even mega caps. Did you know that long before the word “megacap” even existed, small cap stocks dominated the performance metrics? The very-famous-amongst-finance-doctorate academics Fama-French 3-factor model shows a clear historical outperformance of small cap stocks over large cap stocks in its SMB (small minus big) factor (Fama, Eugene F., and Kenneth R. French. 1992. The Cross-Section of Expected Stock Returns. Journal of Finance 47(2): 427–465. https://doi.org/10.1111/j.1540-6261.1992.tb04398.x). Ok, ok, you may have already heard this, but for some strange reason, you are still not convinced, because you have done so well with your large cap stocks. Have a quick look at this chart and then keep reading.
This chart shows the cumulative return of $1 invested in the Russell 2000 Small Cap Index (Red line) versus the S&P 500 (black line). If you are like most people, you immediately looked at the right-hand side of the chart and noticed that the S&P won–hands down. Just by eyeballing the chart, you would see that your $1 turned into $20+ in the large caps and only (only, lol 🤣) $15+ in the Russell. Those actual cumulative returns are 1,837% for the S&P and 1,514% for the Russell. Well, they are both impressive, and I am sure that you can agree, however, looking more closely at the chart you can probably see that the large cap outperformance is a more recent characteristic. Just by eyeballing the chart, you can see that the small caps dominated more often (on a time basis) than the S&P. Why am I going through all of this? Well, because the Russell 2000 Index, which is probably the last thing that you look at when you open my blogpost/newsletter every day, is at its all-time highs! And I would be willing to wager that you missed it–the recent rally that is. 😉 Let’s dig in a little further. Check out this next chart and keep reading.
This chart shows index performance in the pre-GFC (Global Financial Crisis) period from 1990 to 2007. This picture is worth far more than a thousand words. In this earlier era, the Russell 2000 (black line) spent long stretches meaningfully outperforming the S&P 500 (red line). There were periods in the late 1990s and early 2000s where small caps were the market’s workhorses, grinding out better cumulative gains even as large caps enjoyed moments of speculative fervor. The lesson here is straightforward: historically, small companies, nimble, scrappy, and often misunderstood, were rewarded with outperformance. The risk was real, the volatility constant, but the payoff followed. In other words, the small-cap premium was alive and well. Then came the Global Financial Crisis and, more importantly, the world that followed. Now, have a look at another chart and keep reading.
This chart shows index performance in the post-GFC period from 2009 to today. The story changes. The S&P 500 pulls away steadily, consistently, almost uncomfortably. This is the era in which megacaps became the default winners. Free money, quantitative easing, and a tidal wave of global capital flowed into companies with fortress balance sheets and scale advantages. Meanwhile, small caps faced a different reality: higher leverage, weaker profitability, thinner margins for error, and greater dependence on credit conditions. It wasn’t that small caps suddenly became “bad.” No, the regime shifted against them. Check out this chart, then follow me to the finish.
This chart shows Net Debt-to-EBITDA comparison for the Russell 2000 (gray) and the S&P 500 (blue). This is the Rosetta Stone of the entire discussion. Before the GFC, leverage differentials existed but were manageable. Post-GFC, small caps levered up meaningfully while large caps cleaned up their balance sheets. The divergence should be clear–no doctorate required. 😉 The Russell 2000’s net debt-to-EBITDA ratio climbs materially higher than the S&P 500’s and stays there. Add to this the fact that small caps rely much more heavily on floating-rate financing and have far more near-term refinancing needs, and you suddenly understand why interest rate movements have become existential swings for the small-cap universe.
In fact, this leverage gap explains almost everything about the return patterns in the two cumulative charts. When rates fell to zero and stayed pinned there, the Russell 2000 breathed easier because debt was cheap, refinancing was painless, and the cost of capital didn’t punish unprofitable or fast-growing small firms. But when rates rose violently and rapidly, as they did in 2022–2023, small caps felt every last basis point in their income statements. Interest expense soared. Profitability eroded. Risk premia ballooned. The S&P 500, with its beefy balance sheets and access to low-cost long-term debt, barely flinched.
And yet, despite all of this, the Russell 2000 just hit an all-time high. Quietly. Without fanfare. Without mainstream financial network banners or fireworks. It happened because interest rates have finally stopped rising and, looking forward, markets expect them to fall. According to futures pricing, we could get perhaps a full percentage point of rate relief in the next twelve months beginning with next week’s FOMC meeting. For small caps, that’s oxygen. That’s margin expansion. That's a refinancing opportunity! 🍾 That’s breathing room. And markets, as always, sniff the turn before anyone sees it in the economic data.
So what do you do with all of this? First, don’t ignore small caps–especially now. History shows they can deliver extraordinary outperformance when the wind is at their backs. Second, acknowledge the risk. Small caps are volatile, sensitive to credit conditions, and far more exposed to economic downturns. This is not the sleepy part of the market. This is where drawdowns can be sudden, violent, and…um, painful. But this is also where recoveries can be exhilarating and wealth-building. In other words, don’t be lazy and just buy the big names because they feel safe. Safety often comes at the cost of missing opportunity.
As rates drift lower over the next year, the playing field tilts–ever so slightly–back toward the Davids of the market. Do your homework. Know the balance sheets. Understand the business models. But don’t dismiss an entire asset class simply because the last decade belonged to the Goliaths. In markets, regimes change. Leadership rotates. And when it does, the small can once again slay the big.
YESTERDAY’S MARKETS
Stocks had a mixed close yesterday after a tug-of-war session. Investors were jumpy but upbeat ahead of today’s PCE inflation report which will certainly impact next week’s ALL-IMPORTANT FOMC meeting. The Russel hit another all-time high close (in case you were paying attention above) and Bitcoin added a second day of gains to stave its recent drubbing.
NEXT UP
PCE Price Index (September) is expected to have inched up to 2.8% from 2.7%.
Personal Income (September) may have climbed by 0.3%, slightly less than the prior month’s 0.4%.
Personal Spending (September) probably increased by 0.3%, lower than the 0.6% increase in the prior period.
University of Michigan Sentiment (December) may have increased to 52.0 from 51.0. This is one to watch closely!
Next week: still some important earnings along with JOLTS Job Openings, some potential stragglers from the Government shutdown, weekly jobless claims, and the show-stopping FOMC meeting. Check back in on Monday to get your calendars so you can look smart and sharp at your holiday party.
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