How to Understand The Small-Stock Rally
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How to Understand The Small-Stock Rally

Small-caps are drubbing large ones this year. What does it mean for what’s ahead?

By Mark Hulbert
Wed, Mar 10, 2021 5:05amGrey Clock 4 min

Small stocks so far this year have beaten their large-capitalisation brethren by a wider margin than they have in more than two decades, raising questions about what is driving the outperformance and what it means for the overall market ahead.

The year-to-date return for small-caps through the end of February was a remarkable 25 percentage points greater than that of large-caps (as measured by the 20% of stocks with the smallest market caps vs. the comparative quintile of the largest). While it isn’t unexpected for small-cap portfolios to beat large-caps over time—a long-term tendency that Wall Street analysts refer to as the “size effect”—what is unusual is the magnitude of the outperformance. It has averaged just 0.9 percentage point over all two-month periods since 1926, according to data from Dartmouth professor Ken French.

You have to go back to January and February of 2000, at the top of the internet-stock bubble on Wall Street, to find a two-month stretch in which the small-caps beat the large-caps by more. Their margin of outperformance over those two months was 41 percentage points.

Any parallel to the top of the internet-stock bubble is ominous, to be sure. But there are several idiosyncrasies to small-caps’ recent performance that stand in the way of drawing any straightforward analogies to the frenzy in small stocks that heralded the 2000 tech-stock crash.

Indeed, according to several researchers, small-caps’ recent strength may actually be something else in disguise—that is, it may have to do with factors other than just size, such as the battle between growth and value stocks.

That doesn’t mean there is nothing to worry about in this bull market, where valuations are stretched thin for many stocks. But it does mean that investors who are focused solely on the small-cap/large-cap divergence could be missing the bigger picture.

Here’s why.

1. Value versus growth

One distinction that is crucial for understanding the relative strength of small-caps this year has to do with where small- and large-cap stocks lie on the growth-versus-value spectrum. Small-cap stocks currently are far closer to the value end of the spectrum than large-caps, meaning they are trading for lower prices relative to their net worth.

A stock’s place on this spectrum is defined by its ratio of price to per-share book value, with the highest ratios at the growth extreme and the lowest at the value extreme. Consider the Russell Microcap Index, which contains the smallest 1,000 stocks in the broad-market Russell 3000 index. Its average price-to-book ratio was 2.5 as of the end of February, according to Russell Indexes. That compares with a 4.2 ratio for the Russell 1000 Index (which contains the largest 1,000 stocks) and a 5.7 ratio for the Russell Top 50 Mega-Cap Index (which contains the largest 50 stocks).

These are significant differences, according to Kent Daniel, a finance professor at Columbia University and a former co-chief investment officer at Goldman Sachs. He says that, on average, small-cap growth stocks tend to underperform the market, while small-cap value stocks tend to outperform. Since 1926, he says, the smallest-cap stocks closest to the growth end of the spectrum have lost 3.3% annualized, while the smallest most value-oriented stocks have gained 13.3% annualized.

This pattern has been especially strong in recent months, making it difficult to determine what accounts for small-caps’ relative strength this year. But Prof. Daniel says there is the distinct possibility that it is really a “value effect masquerading as a size effect.” If so, a bet on small-cap relative strength continuing is really a bet that value will outperform growth.

That bet may pay off in coming months, he says, and value could continue to outperform growth for many years. But he also says that value stocks have lagged behind growth stocks for at least a decade now, and while there have been numerous predictions of a value resurgence over that time, it hasn’t happened—at least not yet.

2. Sector bets

The benchmark indexes for small-caps and large-caps have different sector weightings, which also makes it difficult to gauge whether the recent relative strength of small-caps is actually due to company size.

Consider the information-technology sector. The ETF benchmarked to the largest 50 stocks currently has a 38.6% weighting to this sector, more than three times the 12.7% weighting of the Russell Microcap Index.

Conversely, the microcap index has more than 10 times the weighting of the largest-50-stock ETF to the industrials sector (11.7% versus 0.8%) and more than double the allocation to the financials sector (17.6% to 7.1%).

These differences are a big part of small-caps’ year-to-date performance, since industrials and financials have each outperformed the information-technology sector. It was just the opposite for calendar 2020, and sure enough, the smallest stocks lagged behind the largest last year.

Until there are small-cap and large-cap benchmarks with the same sector weightings—Prof. Daniel says he is unaware of any currently—it will be difficult to determine what is driving small stocks’ relative strength. If it is being caused by differences in sector weightings, however, it is likely to persist only if the sectors in which the small-caps are overweight continue outperforming.

3. Is the small-cap effect real?

This discussion also points to a more fundamental question that many researchers have been asking in recent years: Does the small-cap effect even exist, in and of itself? That is, do smaller firms really have higher returns than larger firms, on average, over long periods?

Andrea Frazzini, a principal at AQR Capital Management and an adjunct professor of finance at New York University, has concluded that it exists only among a very narrow group of stocks. He says that some of the relative strength of small-caps in recent months traces to speculative fervour for stocks outside that narrow group, making it risky to bet that it will continue.

According to his research, small-caps are a good bet to outperform the large-caps only if you limit your focus to companies with high financial quality. By financial quality he means firms that are profitable, have robust profit growth and a stable earnings stream and a high dividend-payout policy, among other characteristics. Many of the small companies that have performed the best so far this year don’t qualify.

Companies that have been bid higher in recent weeks through social-media investor campaigns—such as GameStop and AMC Entertainment—are two obvious examples, but they are hardly alone in not qualifying for Prof. Frazzini’s high-quality category. Nearly half of the 2,000 companies in the Russell 2000 small-stock index, for example, lost money in 2020.

Prof. Frazzini’s research therefore suggests that, if you want to bet on a continuation of recent small-cap relative strength, you should focus on small stocks that score high on various measures of financial strength, safety and quality. And don’t sweat the comparisons to that internet-stock frenzy of 20 years ago.



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Wealthy Collectors Reveal Signs of Strength in the Art Market—Outside of the Auction Houses
By ABBY SCHULTZ
Fri, Nov 1, 2024 5 min

Sky-high pricey artworks may not be flying off the auction block right now, but the art market is actually doing just fine.

That’s a key takeaway from a 190-plus page report written by Art Economics founder Clare McAndrew and published Thursday morning by Art Basel and UBS. The results were based on a survey of more than 3,600 collectors with US$1 million in investable assets located in 14 markets around the world.

That the art market is doing relatively well is backed by several data points from the survey that show collectors are buying plenty of art—just at lower prices—and that they are making more purchases through galleries and art fairs versus auction houses.

It’s also backed by the perception of a “robust art market feeling,” which was evident at Art Basel Paris last week, says Matthew Newton, art advisory specialist with UBS Family Office Solutions in New York.

“It was busy and the galleries were doing well,” Newton says, noting that several dealers offered top-tier works—“the kind of stuff you only bring out to share if you have a decent amount of confidence.”

That optimism is reflected in the survey results, which found 91% of respondents were optimistic about the global art market in the next six months. That’s up from the 77% who expressed optimism at the end of last year.

Moreover, the median expenditure on fine art, decorative art and antiques, and other collectibles in the first half by those surveyed was US$25,555. If that level is maintained for the second half, it would “reflect a stable annual level of spending,” the report said. It would also exceed meet or exceed the median level of spending for the past two years.

The changes in collector behaviour noted in the report—including a decline in average spending, and buying through more diverse channels—“are likely to contribute to the ongoing shift in focus away from the narrow high-end of sales that has dominated in previous years, potentially expanding the market’s base and encouraging growth in more affordable art segments, which could provide greater stability in future,” McAndrew said in a statement.

One reason the art market may appear from the outside to be teetering is the performance of the major auction houses has been pretty dismal since last year. Aggregate sales for the first half of the year at Christie’s, Sotheby’s, Phillips, and Bonhams, reached only US$4.7 billion in the first half, down from US$6.3 billion in the first half a year ago and US$7.4 billion in the same period in 2022, the report said.

Meanwhile, the number of “fully published” sales in the first half reached 951 at the four auction houses, up from 896 in the same period last year and 811 in 2022. Considering the lower overall results in sales value, the figures imply an increase in transactions of lower-priced works.

“They’re basically just working harder for less,” Newton says.

One reason the auction houses are having difficulties is many sellers have been unwilling to part with high-value works out of concern they won’t get the kind of prices they would have at the art market’s recent highs coming out of the pandemic in 2021 and 2022. “You really only get one chance to sell it,” he says.

Also, counterintuitively, art collectors who have benefited from strength in the stock market and the greater economy may be “feeling a positive wealth effect right now,” so they don’t need to sell, Newton says. “They can wait until those ‘animal spirits’ pick back up,” referring to human emotions that can drive the market.

That collectors are focusing on art at more modest price points right now is also evident in data from the Association of Professional Art Advisors that was included in the report. According to APAA survey data of its advisors, if sales they facilitated in the first half continue at the same pace, the total number of works sold this year will be 23% more than 2023.

Most of the works purchased so far were bought for less than US$100,000, with the most common price point between US$25,000 and US$50,000.

The advisors surveyed also said that 80% of the US$500 million in transactions they conducted in the first half of this year involved buying art rather than selling it. If this pattern holds, the proportion of art bought vs. sold will be 17% more than last year and the value of those transactions will be 10% more.

“This suggests that these advisors are much more active in building collections than editing or dismantling them,” the report said.

The collectors surveyed spend most of their art dollars with dealers. Although the percentage of their spending through this channel dipped to 49% in the first half from 52% in all of last year, spending at art fairs (made largely through gallery booths) increased to 11% in the first half from 9% last year.

Collectors also bought slightly more art directly from artists (9% in the first half vs. 7% last year), and they bought more art privately (7% vs. 6%). The percentage spent at auction houses declined to 20% from 23%.

The data also showed a shift in buying trends, as 88% of those polled said they bought art from a new gallery in the past two years, and 52% bought works by new and emerging artists in 2023 and this year.

The latter data point is interesting, since works by many of these artists fall into the ultra contemporary category, where art soared to multiples of original purchase prices in a speculative frenzy from 2021-22. That bubble has burst, but the best of those artists are showing staying power, Newton says.

“You’re seeing that kind of diversion between what’s most interesting and will maintain its value over time, versus maybe what’s a little bit less interesting

and might have had speculative buying behind it,” he says.

Collectors appear better prepared to uncover the best artists, as more of those surveyed are doing background research or are seeking advice before they buy. Less than 1% of those surveyed said they buy on impulse, down from 10% a year earlier, the report said.

Not all collectors are alike so the Art Basel-UBS report goes into considerable detail breaking down preferences and actions by individuals according to the regions where they live and their age range, for instance. The lion’s share of spending on art today is by Gen X, for instance—those who are roughly 45-60 years old.

Despite a predominately optimistic view of the market, of those surveyed only 43% plan to buy more art in the next 12 months, down from more than 50% in the previous two years, the report said. Buyers in mainland China were an exception, with 70% saying they plan to buy.

Overall, more than half of all collectors surveyed across age groups and regions plan to sell, a reversal from past years. That data point could foretell a coming buyer’s market, the report said, or it “could be indicative of more hopeful forecasts on pricing or the perception that there could be better opportunities for sales in some segments in the near future than there are at present.”

In the U.S., where 48% of collectors plan to buy, Newton says he’s seeing a lot of interest in art from wealth management clients.

“They’re looking for ideas. They’re looking for names of artists that can be compelling and have staying power,” Newton says. “That’s definitely happening from an optimistic standpoint.”

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