Research
The US Small Cap Premium and
the Business Cycle
2016 | ftserussell.com
•
The US economy’s current expansion has lasted more than 85 months and, if history is any guide,
may continue for some time to come. (See Table 1). Nonetheless, it is natural for market participants
to wonder whether we may be approaching the end of this economic expansion and what might
happen to the stock market if and when the business cycle reaches a new peak and an economic
downturn occurs again.
•
This is especially relevant for small company US stocks (“small caps”) as they tend to be more
directly connected to the US domestic economy than their larger brethren, which often have global
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sources of revenue. Our representation of US small caps is the Russell 2000 Index, which
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incorporates the smallest 2,000 stocks of the broad market all-cap Russell 3000 Index. These
2,000 stocks account for roughly 8%-10% of the total market capitalization of the Russell 3000.
•
The main focus of our analysis is on the behavior of the small cap “premium” over the business
cycle, which we will measure as the return difference between the Russell 2000 and the Russell
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1000 indexes. The Russell 1000 Index incorporates the largest 1,000 stocks in the Russell 3000
Index, representing 90-92% of total market capitalization. The designation of premium for this return
difference is based on extensive academic literature identifying a positive return difference between
small caps and large caps over the “long run.” Academics have termed this a risk premium, a reward
2
for shouldering the additional risk associated with smaller companies. One must quickly add that
the premium is often negative for periods shorter than the long run.
1
Previous research and summary of current findings
How have US small cap stocks as represented by the Russell 2000 performed historically at the end of an
economic expansion? Previous research has shown a tendency for small caps to move into positive territory
in advance of economic troughs, before recessions end. In the spring of 2009, for example, in the midst of the
Great Recession, a Russell paper reported that across the four prior US recessions, both the broad equity
Russell 3000 Index and the small cap premium (Russell 2000 Index – Russell 1000 Index) tended to recover
3
prior to the trough, but the small cap premium tended to move earlier. In 2012 these findings were updated
4
to include the Great Recession. FTSE Russell has also published research on the historic performance of
5
the Russell 2000 during periods of rising Federal Funds rates as well as periods of slow economic growth. In
the present paper, we add to this body of work by examining the historical performance of the Russell 2000
around the five expansionary peaks of the US economy identified by the National Bureau of Economic
Research (NBER) since 1979.
1
As determined by the National Bureau of Economic Research (NBER) as of September 30, 2016. The NBER is a private non-profit USbased research organization. It has no official status, but many US government agencies and economists rely upon NBER dates in their
research.
2
Bänz, Rolf, “The Relationship Between Market Value and Return of Common Stocks,” Journal of Financial Economics, 1981; Fama, E.,
and K. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 1992; Fama, E., and K. French, “Common Risk
Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, 1993.
3
Fjelstad, M., “Recessions and the US Equity Market,” Russell Research, May 2009.
4
Fjelstad, M., “Recessions and the US Equity Market, Update 2012” Russell Research, February 2012.
5
Lystra, M., “The Russell 2000 Index in a Rising Rate Environment: Evidence from Past Cycles,” Index Insights, Russell Research,
March 2015; Goodwin, T., “A Stylish look at the Fed” FTSE Russell blog post, August 17, 2015 and “The Russell 2000 Index: Small Cap
Performance in a Slow Growth Economic Environment,” FTSE Russell Insights, September 2016.
FTSE Russell | The US Small Cap Premium and the Business Cycle
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We first look at the US broad equity market as represented by the Russell 3000 Index during the last five
expansionary periods, and then examine the historical performance of the US small cap premium during
these same periods of economic growth. We find that over these cycles:
•
Both the broad market Russell 3000 and the small cap premium (difference between the Russell 2000
and the Russell 1000) turn negative on average 9 months before the peak, the peak being when the
expansion ends.
•
Both the Russell 3000 and the small cap premium return to positive territory on average 3 months before
the peak but the small cap premium on average is substantially above the average Russell 3000 return at
this point (6.53% compared with 2.21%).
•
The Russell 3000 returns to negative territory on average at the peak itself, but the small cap premium,
although reduced, stays positive at this point.
•
The period after the peak until the next trough encompasses the contraction/recession phase of the
business cycle. The average small cap premium stays positive and is substantially above the Russell
3000 broad market return throughout the 12 months after the economic turning point. This is true even
though the broad market return on average rises to 16.4% at +12 months: the average small cap
premium was at that point over 7%. Both averages at the +12 month time point are dominated by the
outcome of the July 1981 cycle.
Our findings support the position that the broad equity market is a leading indicator of the US economy.
Perhaps the most surprising finding is the average forward return strength of the US small cap premium just
before and during a recession.
Methodology
Historical performance data for the Russell US equity flagship indexes—the Russell 3000, 2000 and 1000
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Indexes—begins in January 1979. Our sample period for these indexes spans five complete expansionary
cycles of the US economy as defined and dated by the NBER. The US is currently in a sixth expansionary
period, which began in June 2009. The NBER has not yet announced a peak as of September 30, 2016.
Table 1 reports the details for these last five expansionary periods from trough to peak, in other words, from
the beginning to the end of each expansionary period, including the duration in months of each expansion.
Finally, we include the date when the NBER identified the peak and the lag between the peak (end of
rd
expansion) and the NBER identification date. The current expansion which began June 2009 is the 3 longest
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growth period in our sample. By far the longest of these periods was from March 1991 until the tech bubble
burst in 2001, and the shortest was the brief 12-month period 1980-1981.
6
These three indexes were launched in June 1984. Performance data was simulated to January 1979.
Note that it is possible that the NBER may at some future date determine that the peak for this expansion was experienced prior to the
date of this publication, given the lags that occur between peak points and NBER determination dates. We note from the table that these
lag periods between when a peak occurs and the NBER formally defines the peak has been increasing over our sample period.
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FTSE Russell | The US Small Cap Premium and the Business Cycle
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Table 1. Peaks and troughs of the US business cycle 1975-present
Duration of
expansionary
period (months)
Month of NBER
announcement of
peak
Lag between
peak and NBER
announcement
(months)
Previous trough
(expansion
begins)
Peak
(expansion ends)
March 1975
January 1980
58
June 1980
5
July 1980
July 1981
12
January 1982
5
November 1982
July 1990
92
April 1991
9
March 1991
March 2001
120
November 2001
8
November 2001
December 2007
73
December 2008
11
June 2009
NA
85+
NA
NA
Source: National Bureau of Economic Research as of September 30, 2016
To assess the performance of the broad market as represented by the Russell 3000 Index, we computed the
next or forward 12-month index return at 12, 9, 6, 3 months before and after the economic peaks, as well as
at the exact market turning point itself. For the small cap premium of the Russell 2000 minus the Russell
1000, we calculated the 12-month returns to the small cap premium at the same months-from-peak points:
12, 9, 6, 3 months before and after the economy peaked, and at the peak itself. We report the average
outcomes at each time point. We also add another performance measure that we call the “hit rate.” The hit
rate at each time point is simply the percentage of the five periods where the Russell 3000 Index posted
positive returns over the ensuing 12 months at each time point.
The broad US equity market (Russell 3000)
Exhibit 1 displays the results for our analysis of the broad US equity market based on the performance of the
Russell 3000 Index. On the left hand side of the chart are 12, 9, 6 and 3 months before the economic peak,
while the results for the periods of economic contraction 3, 6, 9, and 12 months after the peak are on the right.
The bars display the forward-looking 12-month total returns to the Russell 3000 Index averaged across the
five periods in our sample at each months-from-peak point. The brown line charts the hit rate of positive
returns, i.e., the percentage of the five periods where the Russell 3000 total return was positive over the
ensuing 12 months.
Prior to the peak, on average the Russell 3000 produced low to negative returns as the economy ran out of
steam. The hit rate declined precipitously from 80% at -12 months (i.e., in four of the-five instances at the 12 month point the returns were positive) to 20% at the -9 month point (in only one of the five instances did
the Russell 3000 record a positive performance). Index returns improved only slightly at -6 months, with low
or negative returns on average and a hit rate of 40% (two out of five) through the peak itself.
Subsequent to the economic high point, we enter the period of contraction/recession. The average return
levels improved after the peak, and by 12 months into the recessions on average the Russell 3000 recorded
returns of over 16%. With the exception of the +9 month mark where we marked a hit rate of 40% (only two
out of five times was the ensuing 12-month return positive) — the hit rates during this part of the cycle were
all at 60%— 3 out of 5 times, the Russell 3000 experienced positive performance in the ensuing 12 months.
FTSE Russell | The US Small Cap Premium and the Business Cycle
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Exhibit 1. Russell 3000 12-month forward-looking returns centered around economic peaks averaged
across five recent expansionary periods
100%
20
Peak
90%
15
80%
70%
10
5
50%
40%
0
30%
Hit Rate
Percent Return
60%
20%
-5
Expansion
10%
Recession
-10
0%
-12
-9
-6
-3
0
3
6
9
12
Months to Peak
Average
Hit Rate
Source: National Bureau of Economic Research, FTSE Russell, as of September 30, 2016. Some returns may be simulated and may
reflect hypothetical historical performance. Past performance is no guarantee of future results. Please see the end for important legal
disclosures.
All periods of expansion were not identical, obviously, and in Table 2 we report the forward-looking12-month
return at each period point for each of the five expansionary periods as well as the average and the hit rate.
For the expansionary period that peaked during March 1991, for example, all returns at all points were
negative, although the loss was smallest at the peak itself. The July 1981 results accounted primarily for the
magnitude of the positive average for the +9 and +12 month points. The pattern of average outcomes, while
informative, were no guarantee of what would have happened during a given (or the next) expansionary
period.
Table 2. Russell 3000 Index forward 12-month returns (%) centered around economic peaks
Months
from Peak
January
1980
July
1981
July
1990
March
2001
December
2007
Average
Hit rate
-12
25.84
14.92
3.92
-22.26
5.14
5.51
80%
-9
11.49
0.00
-10.59
-13.93
-6.06
-3.82
20%
-6
25.12
-2.97
7.50
-27.91
-12.69
-2.19
40%
-3
35.99
-9.21
17.23
-11.46
-21.52
2.21
40%
0
32.51
-13.87
7.22
-8.86
-38.86
-4.37
40%
3
44.03
8.99
34.36
-12.47
-43.51
6.28
60%
6
23.26
20.74
33.66
-17.30
-32.85
5.50
60%
9
-3.57
46.03
13.17
-15.67
-18.62
4.27
40%
12
-4.43
66.58
14.72
-22.17
27.17
16.37
60%
Source: National Bureau of Economic Research, FTSE Russell, as of September 30, 2016. Some returns may be simulated and may
reflect hypothetical historical performance. Past performance is no guarantee of future results. Please see the end for important legal
disclosures.
FTSE Russell | The US Small Cap Premium and the Business Cycle
5
The small cap premium (Russell 2000 – Russell 1000)
Turning our attention to the small cap premium, we see a notably different pattern from that of the Russell
3000, particularly in periods after the peaks. Exhibit 2 displays the results for the small cap premium averaged
across the five historical periods in our sample, centered on the economic peaks. The small cap premium has
tended to be positive during recessions (the right side of the chart) while mixed during the periods of
expansion prior to the peaks (left side of chart). We see that prior to the peaks (the center point on the chart),
the average small cap premium was slightly negative at the -9 month point, turning positive at the -3 month
point, but then falling back to close to neutral at the peak itself. The hit rate (the percentage of the five
expansions where the forward-looking 12 month small cap premium was positive at any give months-frompeak point) during expansions was 60% (three out of five) with the exception of the -9 months-from-peak point
where it was 40% (only two of the five periods have a positive small cap premium).
The small cap premiums for the periods of contraction on the right were substantially positive. The average
size of the premium increased notably at 3 months after the peak, after the economic downturn began, and
was positive in four out of the five instances with a hit rate of 80%. The hit rate increases to 100%—five for
five—at the +6 month mark, and the average premium size was only slightly lower than at the +3 month point.
At 9 months, the hit rate was still high—80% (four out of five)—though the premium size on average declined.
The hit rate declined to 60% but the average was still positive—over 7%—at the 12 month mark.
Exhibit 2. US small cap premium 12-month forward-looking returns centered around economic peaks
averaged across five recent expansionary periods
100%
20
Peak
90%
15
80%
70%
10
50%
5
40%
0
30%
Hit Rate
Percent Return
60%
20%
-5
10%
Expansion
Recession
0%
-10
-12
-9
-6
-3
0
3
6
9
12
Months to Peak
Average
Hit Rate
Source: National Bureau of Economic Research, FTSE Russell, as of September 30, 2016. Some returns may be simulated and may
reflect hypothetical historical performance. Past performance is no guarantee of future results. Please see the end for important legal
disclosures.
As with the Russell 3000 analysis above, we caution that each period in our sample is unique, and all in some
way deviate from the average outcomes charted above. The results for each of the five periods are reported
in Table 3. Returns for the March 2001 period, for instance, were positive at each point and declined to close
to zero at the +12 mark; the January 1980 experience was all positive except at -9 months. The July 1990
sample set had negative premium up to the +3 month time point, while around the July 1981 peak the
premium was negative at the -3 and +3 month marks as well as at the peak itself. The high positive average
FTSE Russell | The US Small Cap Premium and the Business Cycle
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return at the +3 and +6 time points were driven by the January 1980 index returns. Again, while we have
identified a marked pattern in the average outcomes, we note there have been important differences in each
expansion/retraction period.
Table 3. Russell 2000 Index – Russell 1000 Index forward 12-month returns centered around economic
peaks
Months
from Peak
January
1980
July
1981
July
1990
March
2001
December
2007
Average
Hit rate
-12
17.70
16.90
-9.75
7.42
-7.34
4.99
60%
-9
-0.87
4.54
-17.80
15.52
-7.60
-1.24
40%
-6
4.96
2.01
-12.03
7.21
-3.83
-0.34
60%
-3
21.18
-3.52
-7.58
14.94
7.62
6.53
60%
0
6.70
-5.48
-6.36
9.89
1.52
1.25
60%
3
30.72
-0.19
11.31
12.84
1.24
11.18
80%
6
27.68
4.65
13.02
2.03
1.16
9.71
100%
9
3.81
17.42
8.37
5.47
-2.90
6.43
80%
12
7.13
34.06
-0.20
0.12
-2.85
7.65
60%
Source: National Bureau of Economic Research, FTSE Russell, as of September 30, 2016. Some returns may be simulated and may
reflect hypothetical historical performance. Past performance is no guarantee of future results. Please see the end for important legal
disclosures.
Comparisons of the average outcomes for the Russell 3000 and the small cap premium at each months-frompeak point around the peak are the focus of the chart in Exhibit 3. This aids the reader in evaluating what is
common to the broad US equity market and the small cap premium, as well as what sets the small cap
premium apart. Across these five most recent expansionary periods on average both the Russell 3000 and
the small cap premium turned negative in advance of the peak, at the -9 month point, but returned to positive
territory at -3 months, where we observe a strong small cap performance on average. The broad market
receded back at the peak itself, with a notable negative average outcome, but the small cap premium
remained in positive territory at the peak. The Russell 3000 rejoined the small cap premium in positive return
space at the +3 month mark and both stay positive through the last inception point in our analysis, at +12
months.
FTSE Russell | The US Small Cap Premium and the Business Cycle
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Exhibit 3. The Russell 3000 Index and the US small cap premium 12-month average returns centered
around economic peaks
20
15
Percent
10
5
0
-5
-10
-12
-9
-6
-3
0
3
6
9
12
Months from Peak
Russell 3000 Index Average
Small Cap Premium
Source: National Bureau of Economic Research, FTSE Russell, as of September 30, 2016. Some returns may be simulated and may
reflect hypothetical historical performance. Past performance is no guarantee of future results. Please see the end for important legal
disclosures.
Conclusion
Market participants can never know in advance when an expansion might end and a new contraction might
begin, nor how that might impact the equity market. A look back at history can be useful as history doesn’t
repeat itself but it can rhyme. Looking at historical averages of the last five economic expansions and
contractions shows:
•
The broad equity market as measured by the Russell 3000 has on average turned negative several
months before a contraction/recession.
•
The small cap premium as measured by the difference between the Russell 2000 and the Russell 1000
has on average been positive for the forward 12 months beginning 3 months before the peak and through
12 months into the contraction/recession.
That the broad market is a leading indicator of recessions is nothing new. Many economists incorporate broad
market returns in their forecasting models of the business cycle. However, that the forward 12 month small
cap premium has on average been positive – meaning the Russell 2000 outperformed the Russell 1000 –
from 3 months prior to the peaks through the recessions may be surprising to some. We hope market
participants find these insights useful.
FTSE Russell | The US Small Cap Premium and the Business Cycle
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