The correlation between the U.S. large caps (SP500) and the small caps (NYSEARCA:IWM) has become much less reliable as small caps have gone from outperforming to underperforming.
“U.S. small caps have been slowly diverging from large caps for almost a decade now, to the point where it’s best to consider the Russell 2000 (IWM) as a distinct asset class rather than analogous to the S&P 500 (SP500),” Nicholas Colas, co-founder of DataTrek, wrote in a DataTrek Morning Briefing report.
This split was caused by the increasing leadership of the big tech stocks in the S&P 500 (SP500) that started in the late 2010s. Now analysts said they don’t see small caps (IWM) outperforming until the beginning of the next economic cycle.
Looking at the rolling 100-day price return correlations between the S&P 500 (SP500) and Russell 2000 (IWM) from 2009 to the present, from 2009 to 2016, the average S&P/Russell 100-day price return correlation was 0.89, and the band was 0.77-0.97. Then, from 2017 to the present, the correlation has declined to 0.84 and the band is now 0.67-0.97, according to the report.
“Post-2017, there have routinely been larger swings in correlations than before,” wrote Colas. “This new pattern preceded the 2020 pandemic crisis and subsequent events like the 2020-2021 rally in speculative stocks, 2022’s bear market, and the 2023 – present bull market.”
Now, over the most recent 100 days, the S&P/Russell price return correlation has been 0.69, which is the lowest since 2009, during the speculative stock bubble, Colas said.
When it comes to performance, from 2009 to 2016, the Russell (IWM) outperformed the S&P (SP500) by an average of 0.9 percentage points over any given one-year holding period, but after 2017, the S&P has outdone the Russell by an average of 3.5 percentage points over the same period, the report said.
Outside of 2021, large caps have always outperformed small caps since 2017. Over the last year the S&P has outperformed the Russell by 19.5 percentage points.
Finally, Colas said that small caps can still outperform “from time to time,” and that they do best “when blasting off from a cyclical low, one where high yield spreads are declining and the U.S, economy is recovering from a recession.”
