Small cap stocks are having a stellar year with the Russell 2000 Index up nearly 20% year-to-date. In November, small caps outperformed large caps, as measured by the S&P 500, by roughly 9%, the strongest monthly performance in more than 15 years. What’s behind the rally — and more importantly, can it continue?

Written by Russ Koesterich, CFA (BlackRockBlog.com)

Many have pointed to the strong U.S. dollar to explain the small cap outperformance. The argument is a strong dollar supports America’s purchasing power, which helps smaller, domestically-focused companies while hurting larger, more export-oriented firms. This explanation has intuitive appeal, but it ignores two issues.

1. Historically weak relationship between the dollar and small cap relative performance.

• Since 2000 the relative performance of small caps versus large caps has actually had a low correlation with changes in the dollar.
• While the correlation was negative at one point, it has historically been weak, explaining less than 1% of monthly relative returns.
• In short, although commentators have attributed small caps’ outperformance to a rallying dollar, history suggests otherwise.

2. Surge in risk appetite.

• It is important to note that risky assets in general, not just small caps, have had a brilliant run. That reflects the change in sentiment we have seen.
• In fact, risk appetite, as measured by monthly changes in credit spreads, has had a much stronger correlation with the small cap relative performance than the dollar’s strength.
• Since 2000, monthly changes in high yield spreads have explained roughly 10%-15% of small caps’ relative performance.

Can the small cap rally continue?

Going forward small caps face two significant headwinds.

1. The small cap rally is more likely to go on if credit spreads continue to tighten.
   • Unfortunately, a stronger dollar is also a de facto form of monetary tightening, and a further rise in the dollar suggests that spreads are more likely to widen than contract.
2. The second headwind is valuation. The recent rally has occurred at a time when small caps — along with the rest of the U.S. market — are already expensive.
   • Following the recent gains, the Russell 2000 Index is now trading at roughly 47x trailing price-to-earnings (P/E), compared to a five-year average of approximately 39x and, as with the broader U.S. equity market, recent gains have been driven by multiple expansion — investors willing to pay more per dollar of earnings — only more so.
   • Since the lows in early 2016, the trailing P/E on the Russell 2000 is up by more than 40%. In contrast, while large cap stocks have also undergone significant multiple expansion, the P/E on the S&P 500 is up less than 25% from the 2016 bottom. (All data are from Bloomberg, as of 11/28/2016.)

Conclusion

Yes, small caps may continue to advance on other factors, notably an ongoing rally in bank shares (the Russell 2000 has a heavier weighting to banks). That said, a further advance in the dollar, while a headwind for large cap exporters, is not necessarily a tailwind for small caps. Instead, with valuations stretched and 2017 earnings expectations already aggressive, investors are really betting on continued animal spirits and a benign credit market.