In March 2023, small and mid-cap stock indexes sharply underperformed indexes of large-cap stocks. Despite the failure of Silicon Valley Bank (SVB), a large lender to tech start-ups in California and elsewhere, the tech-heavy Nasdaq 100 powered ahead to substantial gains. The S&P 500®, the index to which most large cap U.S. equity managers are benchmarked, managed to finish flat. Meanwhile, indexes of smaller stocks such as the S&P MidCap 400, S&P SmallCap 600 and the Russell 2000 all lost 7.5% to 10% -- an unusually sharp divergence in performance (Figure 1) for indexes that normally display high degrees of correlation (Figure 2). 

Small and mid-cap shares underperformed for two reasons. First, they have a larger share of financial service stocks than their larger peers (Figure 3). Secondly, the failure of Signature Bank and SVB hit small banks and smaller tech firms much harder than it did large banks and large tech firms. Afterall, large tech firms weren’t reliant on the services of institutions like SVB while many smaller tech companies were. Additionally, in March, there was a significant flight of deposits away from smaller, regional banks, whose shares are represented in mid and small-cap indexes, towards the kinds of big banks that feature in the S&P 500.

Source: Standard & Poors, Bloomberg IMAP

Secondly, financial services stocks are more highly represented in small and mid-cap indexes than they are in large-cap indexes. They make up 16.87% of the S&P SmallCap 600 and 15.07% of the S&P MidCap 400, compared to only 12.89% for the S&P 500. Meanwhile, large-cap tech stocks, which strongly outperformed, make up over half of Nasdaq 100, and 26.07% of S&P 500. Tech stocks in the mid-cap and small-cap indexes account for around 10%-13%. So, industry weighting also played a significant role in explaining the divergence in the March 2023 performance among the various indexes.

One should not read too much into March’s performance. Looking back at a longer timeline suggests that during periods of high inflation, volatile interest rates and macroeconomic uncertainty, small and mid-cap stocks often outperformed their larger peers, sometimes even doubling in value on a relative basis. As such, one might wish to consider whether the recent dip in the S&P MidCap 400, S&P SmallCap 600 and the Russell 2000 indexes relative to the S&P 500 and Nasdaq 100 might constitute an opportunity to re-examine the balance of large cap versus small cap firms in a portfolio.

Of the various small and mid-cap indexes, Russell 2000 has the longest history and can give us interesting insights as to the relative performance of small and mid-cap stocks all the way back to 1979. As it turns out, the late 1970s and early 1980s are the perfect starting point because that was the last time the world experienced rates of inflation akin to what we have today. Also, 1979 and 1981 were the last two years in which investors experienced interest rate increases that were as sharp as what we experienced during the past 12 months.

Over the past 44 years, here’s how the ratio of the Russell 2000 to S&P 500 has evolved (Figure 4):

• 1979-82: Russell 2000 small caps soared 77% versus S&P 500 large caps amid rising and highly variable inflation rates, volatile and high interest rates, and a double-dip recession.
• 1983 to mid-1990: Small caps fell 47% versus large caps during the 1980s economic expansion.
• Late 1990 to early 1994: Small caps rose 50% versus large caps as the 1990-91 recession got underway and the economy staged a slow, painful recovery in 1992 and 1993. It’s worth noting that small caps outperformed during this period despite the Savings and Loan crisis among small banks.
• March 1994 to March 1999: During the 1990s economic expansion, small caps plunged 49% versus large caps.
• April 1999 to March 2014: Small caps outperformed large caps by 116% as the U.S. economy suffered two recessions (2001-2002 and 2007-2009), which was followed by a period of slow growth.
• April 2014 to March 2020: Small caps sank 36% versus large caps as the 2010s expansion wore on to the primary benefit of bigger firms.
• April 2020 to March 2021: Small caps jumped 44% versus large caps in the initial phase of the post-pandemic recovery:
• April 2021 to March 2023: Small caps fell by 27% versus large caps as the post-pandemic economic recovery continued. 

There is a consistent theme here: small caps tend to outperform during periods of turbulence that feature volatile interest rates and inflation, and economic downturns as well as early-stage economic recoveries. By contrast, large caps have tended to outperform during the later stages of economic recoveries.  

Small caps’ penchant for outperforming during turbulent times may be explained by three factors:

1. Low levels of debt: smaller firms typically can’t access credit or debt markets as easily as larger ones and thus tend to have lower leverage ratios, and are therefore less impacted by interest-rate volatility.
2. Flexibility and focus: smaller firms tend to be nimbler and can respond to changing economic conditions more quickly than larger ones. The flip side of this is that large firms tend to outperform during the later stages of economic expansions when being nimble counts for less.
3. Exposure to international trade: smaller firms have less exposure, in general, to foreign markets and are thus typically less exposed to geopolitical events and global supply chain disruptions. 

While the Russell 2000 has the longest time series, the S&P SmallCap 600 and S&P MidCap 400 follow nearly identical patterns when seen versus the S&P 500 (Figures 5 and 6). As such, investors whose portfolios are tied to those indexes have also found that the S&P small and mid-caps have tended to outperform the S&P 500 during a period of turbulence and underperform during the later stages of economic recovery. 

The Russell 2000, S&P SmallCap 600 and S&P MidCap 400 also exhibit a strong trend relative to the tech-heavy Nasdaq 100 (Figure 7). These trends are driven to a large extent by the fortunes of the tech sector itself. The tech sector performed strongly during the 1990s and again from 2010-2021. However, it underperformed sharply between 2000 and 2009, and again in 2022. It might be worth asking if sectors, in general, are heading towards a major reversal of fortune where the previous decade’s underperformers turn into winners and the previous decade’s outperformers stumble (our article on sector performance Will 2022’s Near-Perfect Sector Rotation Continue Into 2023?). If so, the Russell 2000, S&P SmallCap 600 and S&P MidCap 400 might outperform Nasdaq 100 in the coming years. 

Finally, it also worth mentioning that the S&P SmallCap 600 and S&P MidCap 400 have strongly outperformed the Russell 2000 index over time (Figure 8). This may be because their investment universes are very different that than those of the Russell 2000, which has no overlap with the S&P MidCap 400 and only partially overlaps with the S&P SmallCap 600 (Figure 9). Additionally, S&P applies stricter criteria regarding the profitability of firms included in their indexes.