In volatile markets, small stocks typically lag larger companies as investors flee what they perceive to be risk. However, this love affair with large-caps is generally short lived as investors return to the beaten-up small caps when the turmoil subsides. Historically, small-caps have outperformed their larger counterparts.
In 2011, junior miners were shunned, but Global Resources Fund (PSPFX) co-portfolio managers Evan Smith and Brian Hicks pointed out to me this week that we're beginning to see signs of small-cap strength.
This chart compares the performance of the S&P TSX Venture Index (TSX), which holds a basket of junior resources stocks, to the returns of the Morgan Stanley Commodity Related Index (CRX). You can see that the junior stocks began to outperform around July 2010 and carried that momentum over a period of six months, reaching a high in March 2011. That's when investor took a turn for the worse and volatility began picking up, sending the TSX tumbling compared to the CRX.
The TSX versus the CRX measure hit a low on December 14, well below the historical average. In technical terms, the December 14 level was 1.37 standard deviations below the two-year mean. Small-caps have only received this level of punishment a little more than 10 percent of the time over the past two years.
If we assume a reversion to the mean—which means these junior stocks would return to the two-year normal range—small-caps could outperform large caps by 20 percent. This bounce back could have a big impact on the Global Resources Fund because of its junior resources holdings.
Recent events have driven the outperformance of riskier investments—we've discussed two of the three recently. Emerging market countries including Brazil, India and China have switched from a tightening mode to an easing cycle, which generally has had a positive effect on the markets. For example, when China lowered its required reserve ratio, there was a record increase in M-2 money supply shortly after.
Also, the JPMorgan Global Manufacturing Purchasing Managers' Index crossed above the three-month moving average.