Small-cap warning

I say this because simple statistics tell us that a few things have in the past predicted annual changes in the FTSE SmallCap index relative to the All-Share index. Three types of indicator matter.

The first are dividend yields. This isn’t surprising. What might be surprising, though, is that when we control for other things it is not small-caps’ yields themselves that have the best predictive power. What matters instead is the yield on the FTSE 100. When this is high – other things being equal – small-caps subsequently underperform. This is simply because big stocks recover after they have been unusually cheap, which means that small-caps underperform.

Two other yields also matter: those on the FTSE 250 and those on the FTSE 350 Low Yield index. Small-caps do well after these have been high – that is, after cyclical and growth stocks have been cheap relative to bigger stocks. Together, these two yields do a better job of predicting small-caps’ relative returns than the small-caps’ yields.

A second set of predictors are interest rates.Small-caps do well after 10-year yields have been low relative to shorter-term rates. You might find this surprising: inverted yield curves predict recessions, which are bad for smaller stocks. Once we control for other things such as dividend yields, however, it seems that small-caps swiftly discount the bad news of an inverted yield curve, which means their prices tend to rise after the curve has been inverted. The rise is, however, usually only small.

A third pair of predictors are the oil price and shipping costs, as measured by the Baltic Dry index. Small-caps do well after these have been low, controlling for other things. This is because such low points come when the world economy is depressed, and that is when smaller and cyclical stocks are out of favour and so are cheap.

Right now, these predictors point to small-caps underperforming the All-Share index in the next 12 months. This is largely because the yield on the FTSE 100 index is well above its post-1990 average, while yields on the FTSE 250 and Low Yield index are around their average. This implies that bigger stocks are relatively cheap, which points to them outperforming smaller stocks.

But how reliable is this signal? Collectively, these lead indicators have explained almost three-fifths of the subsequent annual changes in small-caps relative to the All-Share index since 1991. Notably, they successfully predicted both the best and worst performance of small-caps, during the financial crisis and subsequent recovery.

We can look at this another way, though, by considering how these lead indicators performed in each calendar year. In the past 28 years they have gone seriously awry five times, in the sense of small-caps outperforming or underperforming by 10 percentage points or more when our lead indicators predicted a move in the opposite direction. On four of these five occasions, small-caps outperformed when our lead indicators predicted underperformance: this happened in2012, 2013 and 2015.

This warns us that small-caps can sometimes enjoy reratings – doing better than they should, given valuations and cyclical conditions. Which poses the question: how likely is a repeat of this?

One hope would be that Brexit uncertainty recedes. Insofar as this would increase appetite for risk, it should benefit smaller stocks more – their valuations have been more sensitive to policy uncertainty than those of the All-Share index. Another hope would be that the world economy regains its vigour, which should also help raise appetite for risk and hence smaller stocks – the recent recoveries in narrow money growth in the eurozone and China support this possibility, although the possibility of an intensification of the trade war speaks against it.

There are, therefore, hopes for small-caps despite the fact that valuations are slightly against them. Perhaps, then, they should be part of a balanced portfolio, but not – for now at any rate – a very large part.