Small Caps Show Asset Allocation Key
Key takeaways:
- Small cap stocks had an exceptional run recently, with the Russell 2000 going up 11.5% over 5 trading days – a move that has only happened 32 times in 8700 trading days since 1990.
- This small cap rally was unexpected and caught many investors off guard, highlighting the importance of diversification rather than trying to predict market movements.
- Diversification means “always having to say you’re sorry” – there will always be some parts of a diversified portfolio that lag while others lead.
- The recent dominance of US large cap stocks has made diversification more challenging psychologically, as people are more familiar with large cap companies and their products.
- There are different ways to get small cap exposure (e.g. Russell 2000 vs S&P Small Cap index), and choosing how to implement small cap allocation requires research.
- Market rotations and trends that used to take 12 months to play out are now happening much faster, making it even harder to predict or time the market.
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Small Caps Show Asset Allocation Key – Transcript
Welcome back to the Mullooly Asset Management podcast. This is episode number four hundred and eighty two. I’m Tim Mullooly here with me today is Brendan and Tom Mullooly.
How about those small caps? We wanna talk about small caps today and it kind of ties back to a few episodes ago or the topic of diversification in particular. Over the last week or so small caps have had a really eye opening run of good performance here.
Tim used the quote that you wrote in our message when we wanted to talk about this: “Small caps has had a really great year in the last seven days.” It’s true, I have the numbers. The Russell two thousand has gone up eleven and a half percent over the last week. That’s five trading days.
It’s incredible. In eighty seven hundred trading days since nineteen ninety it moved like this for the Russell two thousand has only happened thirty two times. And it’s a violent reversal of the trend that we’ve been seeing recently in the sense that the Russell is doing this while the S and P five hundred and the Nasdaq are mostly doing nothing.
I think that in addition to the move is what is so stark and it’s called basically everybody off guard or offside if they were trying to position things for the immediate future as opposed to looking at the bigger picture and using small caps as a piece of a diversified portfolio as we are often coaching our clients to do.
It’s interesting to note that you cited however many trading days going back to nineteen ninety, in nineteen ninety, when we were in nineteen ninety one and nineteen ninety two when we were rotating the market leadership from one size cap you know from say large cap to small caps and then mid caps, those kind of rotations would take twelve months. It would take us a year for these things to happen. Now they’re happening much, much faster.
And so it’s very hard to see these things coming. I think it’s happened before like you pointed out it’s rare. But I remember even just a few years ago you know, a point that we make to people when questioned about you know why do we own this? Why do we own that?
There was a few years ago where small caps in particular had a really, really good fourth quarter of the year. And we used that same line that I said before: Small caps had a great year. Just in the fourth quarter. This time is even a shorter window than that just seven days not even over the span of a quarter.
Both of you have said now it’s something that you can’t see coming. It’s just a point towards diversification like we’ve been talking about over the last few episodes just consistently having exposure to these areas.
Maybe a note to add to, the stats I’m quoting are from DataTrek Research. It’s interesting because all almost all of the other occurrences of moves like this for the Russell two thousand as rare as they are fell into kind of like two broad buckets in terms of what else was happening during those periods to maybe explain the movement a little more.
And those two buckets were either bear market rallies or right after major market lows when small caps did this over a five day stretch neither of which apply right now. Almost the exact opposite honestly.
And so also from DataTrek, they tacked on like a Wall Street adage to this information that I think is worth sharing. And they said “just because something has never happened before doesn’t mean it isn’t happening right now.”
And I think that coupled with the idea that absolutely nobody was calling for this a week ago a month ago whatever you want to call it is a broader point about being diversified and not needing to predict these unpredictable happenings when you are diversified that’s the important part.
That is very important but that’s the point. Or, to take it another step even just like believing whether or not it this is real. You know what I mean? It’s like, it’s never really happened before. So people are like oh this this can’t possibly happen. Like it’s not this isn’t a real move.
Like it’s just gonna revert. It’s like it doesn’t you don’t have to believe whether or not this is. New things happen at all. Real. Exactly. It’s just because it hasn’t happened before doesn’t mean it isn’t currently happening for the first time.
I wanna share one of my favorite quotes, promise last quote for the episode from Daniel Kahneman, that I think, supports our philosophy of diversification, and goes hand in hand with what we’re talking about. And it’s “whenever we’re surprised by something even if we admit that we made a mistake we say oh I’ll never make that mistake again. But in fact, what you should learn from when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That’s the correct lesson to learn from surprises. That the world is surprising.”
Right. Not specifically that like you should have dug in. This one to find this anomaly with small caps that have alerted you to allocate to them prior to this move. No it’s never anything as specific as that.
It’s that the world is surprising and you cannot predict these things. And so of course, you make some decisions even when you’re diversifying to pick which areas are worthwhile to allocate to over the long term.
It’s not that we want to own a little bit of everything because we’re so ignorant. We make some choices about where we’re going to allocate money for reasons that are backed up by research, historical data, and we got to give those the time to flesh out and even in eighteen month run like we’ve seen with large cap beating a crap out of small caps, is not enough to reverse the historical precedent that made us put money into small gaps to begin with.
And that I think applies to almost any area of the portfolio. It’s excruciating when you got to live through it and you do the work to make sure that you’re not missing something but most of the time you aren’t you just got to be patient.
Yeah I think we talked about it on a an episode earlier but it we get questions like why can’t we just put all of our money into US large cap tech stocks? And it’s like, this seven day run-in small caps is is a good example of why we don’t do stuff like that.
We and we don’t know of course, when it comes to any move like this over the short term whether it will continue or not but I think that if you’re if you’re only allocating to what’s working now you are by definition always going to be chasing your own tail and I think that that’s going to lead to very good performance over the long term.
Probably feels good when you do it because it’s rewarding to just do whatever’s working right now but I don’t think that that’s a prudent approach over the long term when it comes to investing.
Yeah And I feel like that applies. We’re talking specifically about like, small cap stocks here and that’s drilling down even a layer deeper than just stock bond exposure. But the same thing we’ve talked about that in the past about stocks for as bonds, just diversifying in general.
It’s not specific to asset class or just like high level allocations stuff like that. It’s interesting to see reading the same pieces from DataTrek, Brendan that you referenced where they speculated that part of this may be money coming out of big tech um a big tech names that are large cap that seem to overwhelm the S and P five hundred now.
Some money coming off the table there and going into almost like a rebalance where they’re putting money into small caps. Now that’s just to speculation, you know for the same reason why is there a lot of traffic on Route thirty four, on Thursdays and Fridays or why is there a lot traffic.
You’re trying to explain decisions that other human beings have made which you cannot possibly do. However it’s helpful. He said it way better than that. But it’s helpful to think through the reasons why something may be occurring.
It doesn’t mean that you need to latch on to any individual theory and like back up the truck and bet your money. I think it’s helpful to think it through as part of a process but uh you know to I actually I have a thought about what Tim was saying with diversification and this this recent period of like US large cap domination, just thinking through diversification is never easy but I feel like it has been even more difficult because the US large cap stock universe is like the most familiar stock market piece of the stock market, that everybody knows.
And so the idea that that was the area outperforming most recently it just makes it so much more salient I think for people to like see the names that make up the large cap indexes and be like why don’t we just own these things.
And I don’t think you get the same scrutiny if you’re in a period where like small caps or international stocks are outperforming because nobody cares. There’s companies that nobody’s ever heard of. And nobody cares what like European stocks are doing. That’s not in their face every day like the components of the Dow.
And seeing the names at the bottom of the Russell down. It’s like we don’t even we hardly know the names in the small cap indexes or at least we’re not like familiar with them in the sense of like using their products on a day to day basis.
And so I’m not saying that that’s an okay reason to get caught up and be undiversified, but I think that that could explain how people got so caught off guard over the last week because when something like that happens it’s just it’s so easy to just be like yeah like I’m just I’m just gonna own the largest companies in the world and I use their products every day. So why wouldn’t I? Like this is obvious and everyone who doesn’t do this is stupid.
Yeah I think it makes it easier for them to understand like oh Apple’s. Apple’s doing well I have an iPhone. Like I know Apple see the commercial focused on Netflix. That’s right. Today’s Amazon Prime Day. Exactly yeah.
Like it makes it easier to understand and sometimes just investing and finance in general is like very foreign to a lot of people. And it’s just like if you were to say small caps are doing well it’s like what’s small cap. And then it’s like oh let me name some small cap companies and they’re like I’ve never heard of these before. Moe I don’t understand it I don’t get it. Is foreign to me.
And I think that if you remove the last five to ten year period from the historical data and look back it would have been to your detriment who only pick large cap US stocks like all these other areas, I think have enough historical data to back them up to say hey yeah even though you don’t understand these as much as you might US large cap socks you should probably still allocate to them in some capacity if you wanna be diversified and you don’t wanna have to guess when the tide is turning in the market you know from large cap to small cap or towards the Internet or value stocks.
Yeah. And I think the performance too like it’s all relative. It’s not to say that over that period of time that these anything other than US large cap socks haven’t been making money. You know like they have been performing solidly, not just not as well as the US large cap.
So it’s not like you’re out there getting pummeled in some of these other areas. Like you’re still making money if you have money in the over the long term. It’s just a trade off of you know if you’re owning portions of all of these different asset classes and different types of investments, you know you’re not feeling one hundred percent of the US large cap exposure.
And I’m a proponent. I’m sure we said uh in no more quotes but not a quote. During that last episode you were referencing before Tim I’m sure that we made reference to the idea of diverse vacation meaning always having to say you’re sorry.
Yes. Yeah I mean you’re always by definition. If you’re diversified you’re always gonna have something that is lagging in the portfolio and something that is leading, and that’s part of it.
And that can work in your favor over the long haul if you can stay disciplined and stick with the strategy rebalance back into the areas that that are lagging, and take some profits from the ones that are leading over time that’s what it’s all about but nobody said it was gonna be easy.
Simple sometimes. It can be simple but not easy. We say that a lot too. Yep. It’s also hard to do when it’s time to do it. That the other part of, behaviorally, it’s it feels the opposite of what you of what your gut wants you to do or what feels good.
I think there’s also, a lot of misunderstanding when we talk about small caps in the sense that, you know they’re small caps in general and then small cap growth, small cap value. Uh there is the Russell two thousand. There is the S and P small cap index.
These are, you know when ETFs were initially created they were based off an index so it was race to create indexes because then we could build an ETF off of it. But there’s pretty large difference between something like the P small cap index and the Russell two thousand. Do we want to talk about that?
Yeah I mean I just think in general like you can get different flavors of small cap exposure and having them at all in your portfolio is a decision that I think is beneficial but then beyond that, and probably the part that most people are relying on us to research for them is like if you wanna own small caps, how do you do it.
And to your point, these different indexes can get you different flavors of small cap exposure and that’s gonna impact your performance over the long haul. So I mean that’s something that we’ve spent time in the weeds thinking through for people. And you know we have our reasons for how we get that exposure in the portfolios, but Yeah.
So I think that you know good discussion on small caps. They’ve been in the headlines recently for a good performance but overall just another beneficial discussion about diversification. It’s a good place to wrap up.
That was episode four eighty two of the Mullooly Asset Management podcast. Thanks for listening and we’ll see you on the next episode.
Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.
