The large-cap to small-cap ratio is a measure that compares the total market value of large-cap stocks to the total market value of small-cap stocks within a particular market or index. It is used to assess the relative performance and valuation of large-cap and small-cap companies. Differentiating between these characteristics is a popular way to segment the US stock market (next to growth and value). The term 'cap' stands for market capitalization, which is a metric to assess the size and value of a company. Market capitalization is determined by multiplying the stock price by the number of outstanding shares.
Large-cap stocks are generally considered as less risky. These tend to be companies that are very stable and dominate their industry.
Small-cap stocks are generally considered to be riskier and more profitable than large-cap stocks. Many small caps are young companies with significant growth potential but also a higher risk of failure.
The ratio in the chart above divides the MSCI USA Large Cap Index by the MSCI USA Small Cap Index. When the ratio rises, large-cap stocks outperform small-cap stocks - and when it falls, small-cap stocks outperform large-cap stocks. The ratio peaked in 1999 during the dot-com mania.
Interestingly, the Small-cap/Large-cap ratio correlates quite strongly with the 10-Year (expected) Inflation Rate which is calculated as the difference between the Treasury Rate and the TIPS Rate.
According to Aswath Damodaran, historically, small-cap stocks have outperformed large-cap stocks during periods of high inflation, such as the 1970s. In a podcast he explained how small-cap companies exhibit greater flexibility and adaptability in response to changing economic conditions. Unlike large-cap companies, which may face challenges in adjusting their operations and pricing structures, smaller companies have the ability to swiftly pivot and capitalize on the opportunities presented by inflation.
Together, the components of the MSCI USA Large Cap Index, MSCI USA Mid Cap Index, MSCI USA Small Cap Index, and MSCI USA Micro Cap Index comprise the MSCI USA All Cap Index without gaps or overlaps.
The MSCI USA All Cap Index is the broadest of the indices. As of June 2024, the index includes 3,510 constituents across large, mid, small and micro capitalizations, representing about 99% of the US equity universe.
The MSCI USA Large Cap Index is designed to measure the performance of the large cap segments of the US market. With 278 constituents, the index covers approximately 70% of the free float-adjusted market capitalization in the US.
The MSCI USA Mid Cap Index is designed to measure the performance of the mid cap segments of the US market. With 334 constituents, the index covers approximately 15% of the free float-adjusted market capitalization in the US.
The MSCI USA Small Cap Index is designed to measure the performance of the small cap segment of the US equity market. With 1,765 constituents, the index represents approximately 14% of the free float-adjusted market capitalization in the US.
The MSCI USA Micro Cap Index is designed to measure the performance of the micro cap segment of the US equity market. With 1,133 constituents, the index represents approximately 1% of the free float-adjusted market capitalization in the US.
The chart above displays the 1-year rolling correlation coefficient between the MSCI USA Large Cap Index and the MSCI USA Small Cap Index. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that the two indices moved in the same direction during the specified time window. Conversely, a correlation coefficient of -1 indicates that they moved in opposite directions. The chart shows that the correlation between large-cap and small-cap equities is mostly positive. The correlation coefficient is important for diversification because it helps investors assess the potential benefits of including both large-cap and small-cap equities in their investment portfolios.
Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
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