Investing in Small-Caps Following a Market Downturn

Every bear market comes to an end, or at least it has so far.

Of course, no one knows exactly when that will be so there are bound to be a few false starts. In this case, just as the Fed appeared to be temporizing on rate increases, Chairman Powell weighed in following the November meeting and pulled the rug out from a nascent market rally. Bloomberg economists are predicting an end rate for Fed funds of better than 5.0%, well above the current 4.0% (Bloomberg, Oct. 28).

But given that we started with Fed funds around zero we’re likely closer to the end of this cycle of tightening than to the beginning. The latest CPI numbers (up 7.7%, down from 8.2% the month before) and the subsequent jump in stock prices suggest as much (New York Times, Nov. 10). Assuming that’s the case, investors should begin to look through the daily headlines to a period when rates stop moving up and markets recover. They can then start to position their portfolios accordingly.

Data has shown that small cap stocks tend to lead following a period of economic dislocation. With their more domestic business focus, they have also done well in times of a rising dollar. Current conditions check both of those boxes: the economy has been under stress and the dollar has soared for much of this year. While the past is not always prologue, small caps have outperformed large caps following nearly every bear market of the last century.

Using the S&P Small Cap 600 as a proxy and comparing returns to the S&P 500, you can see how this has played out following the last three major market downturns starting with the Dot Com crisis. From October 2002 to October 2005, the S&P Small Cap 600 returned 22.04% on a compound annual basis. The S&P 500 was up 17.14% over that same period, an excess return of 4.90% per year for small caps. (Source: FactSet)

The effect was even more pronounced following the Global Financial Crisis. For the period March 9, 2009 through March 9, 2012, the S&P Small Cap 600 rose at an annual compounded rate of 37.22% compared to 29.20% for the S&P 500. Here the excess return for small caps was 8.02%, compounded annually. Finally, there was the post-Covid market, defined as the period March 23, 2020 through October 20, 2022. Here the S&P Small Cap 600 was up 29.43%, compounded annually. The S&P 500 was up 23.40% for the same period, an excess annualized return of 6.14% per year for the small cap index. (Source: FactSet)

The IQ Chaikin U.S. Small Cap ETF (NYSE: CSML) is one way to gain broad exposure to the universe of small cap stocks. CSML uses a multi-factor approach to security selection that focuses on value, earnings growth, sentiment, and selected technical indicators. It generally holds 200-350 securities, equally weighted, selected from the Nasdaq US 1500 Index.

Diversification across asset classes and market capitalizations is generally a good idea for most investors, and that includes an allocation to small cap equities. Although we do not have a crystal ball to know when the market will find firmer footing, if history is any guide, the period following the end of a market downturn might be an especially good time to have exposure to the small cap sector.

Moreover, through its multi-factor methodology, CSML offers the added benefit of reduced single factor sensitivities while preserving outperformance potential. The merits of this approach have been demonstrated most recently during the post-COVID period, defined as March 23, 2020 through October 31, 2022, during which CSML outperformed the S&P 600 small cap index as well as the value, growth, and momentum factor versions of the S&P 600 index. For those considering establishing or adding to a small cap position, CSML presents a compelling option.

Related: Time for the “Hedge of Least Regret”?