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Where are we in the small cap cycle?

By: Tom Goodwin, senior research director

Market participants are often told that they should evaluate an investment proposition over a “full market cycle.” However, there is little guidance on what exactly a full market cycle might look like or how long it might be. It is easy to conflate a market cycle with the economic business cycle. There is indeed a relationship between the business cycle and the small cap cycle, as we have documented in a research paper,[1] but to say there is a relationship is not to say they are the same. The purpose of this post is to estimate the size and duration the small cap cycle through the history of the Russell 2000 Index and to ask what this might show about the current cycle.

Borrowing the language of business cycle analysis, a full cycle includes both contractionary and expansionary phases. In a previous blog, we analyzed the small cap universe using the Russell 2000 Index and determined that based on historical trends, we may be in the middle of an expansionary phase for this segment of the market. In this blog, I want to show how we arrived at that conclusion.

To determine when a contraction or expansion begins for a particular segment of the market we must define the peaks and troughs of that segment – in this case small caps. A contraction is the period between a peak and a trough, and an expansion is the period between a trough and the next peak. For this analysis, I used the history of the small cap Russell 2000 Index and defined a trough as the bottom of a more-than-20% correction. The peak would then be the high point prior to the trough. As seen in the chart below, starting in December 1978, I found 11 peak-trough pairs. The exact dates and summary statistics are in the table below.

The threshold to qualify as a market correction is, inevitably, somewhat subjective. I chose more-than-20% based on “eyeball intuition” that suggested 20% was a good compromise. A 15% threshold would have added one more peak-trough pair, while a 25% threshold would have removed one peak-trough pair, so the dating is not overly sensitive to that choice. 

Source: FTSE Russell as of August 21, 2017. Data before January 1, 1984 is hypothetical. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

Historical recessions and expansions of the Russell 2000 Index 

 

Source: FTSE Russell as of August 21, 2017. Data before January 1, 1984 is hypothetical. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

As we can see over the last 40 years, the average expansionary period has lasted 750 days with an average index return of 133.8%. As of August 21, 2017, we are 385 days into the current expansionary period and the Russell 2000 Index return is up to only 45.4% – both statistics significantly below the historical average and median for expansionary phases.

So which way is the cycle headed now? The research provided above suggests that the current state of the small cap cycle is only about halfway through the average historical expansionary period. This is strictly based on past events, of course, and previous cycles are not guaranteed to repeat going forward, but it is very interesting nonetheless. 

 

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[1] Please see the FTSE Russell Small-Cap Premium and the Business Cycle Insights Paper

 

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