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 Wilshire US Large-Cap Index by the Wilshire US 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. This ratio is used as an indicator of market sentiment and investor preference. When the ratio is high, it suggests that investors have a preference for larger, more established companies, indicating a potential bias towards stability and lower risk. On the other hand, a low ratio indicates a preference for smaller, potentially higher-growth companies, reflecting a higher appetite for risk and potential returns. 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 Wilshire US Large-Cap Index, Wilshire US Small-Cap Index and Wilshire US Micro-Cap comprise the Wilshire 5000 without gaps or overlaps.
The Wilshire 5000 is the broadest of all listed indices on this page. It measures the performance of all U.S. equity securities with readily available price data.
The Wilshire Large-Cap includes the top 750 ranked components of the Wilshire 5000 index measured by market capitalization.
The Wilshire Mid-Cap includes the components between 500 and 1000 measured by market capitalization. Therefore it's considered a benchmark for mid-cap stocks. The components of the Wilshire US Mid-Cap are the bottom 250 Wilshire US Large-Cap securities and the top 250 Wilshire US Small-Cap securities by capitalization.
The Wilshire Small-Cap includes the components between 750 and 2500 measured by market capitalization.
The Wilshire Micro-Cap includes the components ranked below 2500 measured by market capitalization.
The chart above displays the 1-year rolling correlation coefficient between the Wilshire US Large-Cap Index and the Wilshire US 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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