The thing about smaller firms is that they are more likely to fail or get into serious trouble than larger ones - which is why the sector tends to do badly when investors worry about recession, as they did in the early 90s and in 2008. This vulnerability, however, exposes them to more than just recession risk. Joachim Grammig at the University of Tubingen and Stephan Jank at Frankfurt School of Finance and Management point out that it also makes vulnerable to creative destruction. A wave of technical progress or emergence of new firms which makes older businesses obsolete is more likely to hurt smaller firms than bigger ones, because the latter are often better protected from competitive pressure. Over the long run, they say, smaller stocks must offer better returns than big ones to compensate investors for this extra risk.
Herein lies a reason why small caps' good performance might be a sign of economic failure. If there's less creative destruction - less technical progress - then small caps are less risky. Their big price rise might therefore be a re-rating which reflects their reduced risk.
And there are good reasons to think that creative destruction - or if you prefer, competitive pressure - has diminished since the mid-00s.
■ Labour productivity has fallen. Output per worker-hour is 4.6 per cent lower than it was at the start of 2008. You could see this as a sign of slower technical progress. Or you could - and should - see it as evidence that the rate of entry and exit in businesses has declined; Jonathan Haskel at Imperial College London has shown that lots of productivity growth comes not from managers improving the efficiency of existing firms, but from new, productive ones entering and less productive ones leaving. Lower productivity is thus a sign that this "external restructuring" has declined. Research at the Office for National Statistics has found a "weakening in competitive pressures to weed out less productive firms, especially in the service sector".
■ Investment has fallen relative to GDP and corporate profits. This is partly a symptom of a dearth of investment opportunities, which in turn reflects slower technical progress. One of the main drivers of creative destruction is thus weaker now.
■ This recession has seen surprisingly few firms go bust. Since 2009, an average of around 1200 firms have gone into receivership, compared with more than 7,800 in the 1991 recession. There has, says Ben Broadbent of the Bank of England's monetary policy committee, been a "surprisingly low level of firm exits".
■ Mr Broadbent points out that, across sectors of the economy, the variance of price changes has increased since the mid-00s. This, too, is evidence of reduced creative destruction. In a healthy economy, we'd expect companies to enter a market where prices are rising fast and leave where they're falling, which should put a limit on both price rises and falls. A higher variance of prices is thus a sign of reduced entry and exit.
All this evidence adds up to a picture of reduced creative destruction. This means smaller stocks have become less risky. Which justifies their price rise.
Herein, though, lie two dangers for the sector. One is simply that higher prices and less risk should mean lower expected returns. Barring a surprise, therefore, small caps should do less well from now on.
Secondly, it's possible that creative destruction will re-emerge some time. This could happen if: technical progress picks up; if the dearth of investment opportunities recedes; if banks' better capital base encourages them to step up their lending; or if creditors' forbearance towards struggling firms declines. If or when this happens - and as Mr Broadbent says, it is very uncertain - then small caps might suffer. In this sense, they are especially risky investments.
