13 Dec The Size Effect & The Reflation Trade
U.S. equity markets have surged post-election with small companies leading the way. The Russell 2000, a common small company index, was up 11.0% while the large company biased S&P 500 gained 3.7% in November. Many suggest that small company outperformance is due to optimism over increased economic growth. If this optimism is reflected in inflation expectations, historical performance gives little indication that small companies should outperform large companies when inflation expectations have increased.
First, consider how small companies perform when the equity market makes large moves (positive or negative). A review of monthly performance from July 1951 to October 2016 indicates that small companies do not tend to outperform (or underperform) large companies. This result does not contradict the well-documented “size effect.” Instead, it highlights one must be mindful of the construction methodology for most barometers of the equity market as many tilt toward large companies, for example.
In addition, your view of small company outperformance is a function of your chosen barometer. A broader view of the equity market shows lower relative performance than the frequently referenced indices.
Second, do small companies tend to outperform during periods of increasing inflation? Using the consumer price index as a measure of the U.S. inflation rate, a positive year-over-year (YOY) change shows that inflation has increased. There is little relationship between increased inflation and small company outperformance.
The lack of a relationship extends to inflation expectations. To gauge expectations, Treasury Inflation-Protected Securities (TIPS) are an accepted market-based measure. The scatterplot below shows the small company relative performance compared with the 5-year Breakeven Inflation Rate.
In short, there was little to no precedent for the small company outperformance in November. This doesn’t answer the question of why, but it does advance an argument against the belief that growth (manifested in the form of increased price levels) premised on tax cuts and spending increases should drive small company prices up.
Methodology
- Time series ranges are from July 1951 to October 2016.
- The relative performance is the SMB (Small minus Big) factor return from the Kenneth French library.
- St. Louis Federal Reserve is the source of Inflation expectations time series; January 2003 – October 2016.