Small caps' fake allure

This year looks like being a better year for the UK's economy than for the eurozone's. Latest purchasing managers' surveys show that UK manufacturing activity is now rising while the euro area's is falling, which is consistent with economists' forecasts that UK real GDP will grow by around 1 per cent this year while the euro area's will probably stagnate.

It's tempting to think that this is a reason to favour smaller UK stocks over larger ones, as small caps are generally more domestically-oriented than global FTSE 100 companies. History, however, suggests this would be dangerous.

This is because the correlation between UK small caps and UK industrial production, relative to the euro area's, is actually negative: for annual changes, the correlation coefficient has been minus 0.31 since January 2000. This tells us that when UK output grows faster than euro area output, small caps are more likely to fall than rise. Not certain to fall, note, but more likely than not.

There's a simple reason for this. UK output is massively correlated with euro area output; for annual changes in the two, the correlation has been 0.92 since January 2000. This means that when the euro area does badly, so too does the UK. And it's in these circumstances that UK output is likely to outperform the eurozone, because our output is less cyclical than theirs. In 2009, for example, UK output fell less than the eurozone's, in part because the latter tends to specialise more than the UK in very cyclical industrial goods.

This implies that the circumstances in which the UK economy outperforms the eurozone are likely to be circumstances in which investors are worrying about global growth generally. These are conditions in which shares do badly - so small caps fall.

What's more, history suggests that the odds of them outperforming large stocks are in such circumstances are no better than 50:50. This is because when investors worry about global growth, they tend to prefer familiar big-name stocks, and this offsets the advantage small caps have of being exposed more towards the safer UK economy.

The message here is simple. Worries about the eurozone are no reason to favour small caps. Euro-pessimists should be light on equities generally, and hold more cash and better-quality bonds.

Conversely, the best hope for small caps would be a eurozone recovery, as this would improve sentiment towards equities generally. Most economists expect such a recovery later this year. It is if they are right - and it is an 'if' - that small caps are more likely to do well.

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