One big fact suggests that small-caps' recent underperformance might continue. It's that there has for almost 30 years been a strong tendency for the performance of small caps relative to the FTSE 100 to mean-revert; good times for small stocks lead to poor times, and vice versa. Since 1985, the correlation between the ratio of the two indices and changes in that ratio in the following three years has been a hefty 0.69. This implies that this ratio alone can explain almost half of the variation in three-yearly returns on small stocks relative to the FTSE 100. Right now, this relationship points to small caps underperforming the FTSE 100 by five percentage points a year for the next three years.
There are two reasons for such mean-reversion.
One is that the size distribution of companies shouldn't change much over time. Robert Axtell at the Brookings Institution says this distribution fits Zipf's law closely and is "quantitatively invariant over time". Of course, the identity of the giant companies will change - corporate death rates are high - but their frequency doesn't.
If you doubt this, just imagine what would happen if it were not the case. If big companies grew faster than small ones then eventually the economy would be dominated by a handful of monopolies. And if small ones grew faster, then monopoly power would eventually disappear entirely and we'd have an economy with textbook perfect competition. In the last 200 years, we've seen neither of these developments. So it's reasonable to suppose that Dr Axtell is right.
This implies that the returns on small stocks and the FTSE 100 are, in economists' jargon, cointegrated - they should rise at about the same rate over time. This in turn implies that short-term deviations between them should be corrected.
Think of the two as being like a drunk walking his dog home from the pub. At any point in time, the two might be some way apart. But eventually they'll get home together. And this tells us that when they are far apart, then they must move closer together.
But what causes such short-term departures, which might last several years? Here comes the second part of our story. It's that the performance of small caps is cyclical. In the last 40 years, we've seen three big up-cycles in them relative to the FTSE 100: in the 1980s, early 2000s and since 2010. These have been interspersed with long down-phases, such as in the 1990s and late 2000s.
This fits the pattern of evolutionary finance, as proposed by Andrew Lo at the Massachusetts Institute of Technology. Investment strategies, he says, "undergo cycles of profitability and loss in response to changing business conditions, the number of competitors entering and exiting the industry, and the type and magnitude of profit opportunities available."
So, for example, in the early 80s investors saw that small caps had done well and so started to buy them; specialist small-cap funds proliferated. This drove up small-caps' prices. But by the late 80s, these had risen so far that they were unsustainably high. The upshot was that small caps began to underperform. As they did so, small-cap investors grew disillusioned and so continued to sell, By the late 90s, their selling had driven small caps down too far with the result that the up-cycle began again. And so on.
We might now be at the top of the cycle for small caps. Their relative prices are so high as to be unsustainable and anyone who is going to be a small-cap investor already is, and so there might be more marginal sellers than buyers.
If this is right, there's an obvious implication - be wary of being overweight in small stocks - and a less obvious one.
This is that active stock-pickers might be about to do relatively badly.
When small caps outperform even stock-pickers of average ability and luck should beat the market. This is because market indices are weighted by market capitalisation and so are dragged down when big stocks underperform. This means that equal-weighted baskets of stocks should outperform, even if they are selected at random. To put this another way, if small caps outperform, most stocks will beat the market simply because there are more small stocks than big ones. And this makes life easier for stock-pickers.
When, however, big stocks outperform, this goes into reverse. They drag market indices up, with the result that only a minority of stocks outperform the market. Stock-pickers then find themselves fishing in more sterile water.
In this sense, if small caps are about to underperform, the case for holding tracker funds becomes stronger.
