The dollar’s moonshot in recent months has resuscitated a stock market leadership argument we haven’t heard for a long time—namely, that Small Cap stocks are better insulated than Large Caps from the loss of competitiveness and the currency translation impact of a stronger buck. Is there merit to this argument, or are Small Cap proponents grasping for straws after a flat year? It turns out there’s reasonable support for the Small Cap enthusiasts’ view, based on evidence from the U.S. (trade-weighted) Dollar Index. Isolating all dollar swings of 15% or greater since 1971 yielded the following performance results:
Small Caps have, on average, outperformed Large Caps during periods of sustained U.S. dollar strength, generating an annualized total return of +13.6% versus +10.7% for the S&P 500. This 2.9% performance spread is significantly higher than the +0.9% per annum performance edge earned by Small Caps over the full 44-year period. In contrast, Small Caps compounded at just +9.2% during periods of dollar weakness, below the S&P 500 figure of +10.4%.
While the full-period results support the fundamentalists’ argument, the late 1990s stand out as a costly counter-example—with Large Caps clocking Small Caps for five consecutive years (1995 to 1999) despite an historic dollar rally that “should” have favored more domestically-exposed companies (i.e., Small Caps). Recent experience also runs counter to the long-term results; the current U.S. dollar strength kicked off in April 2011—coinciding to the month with the cycle’s Small Cap relative strength peak. Overall, we’d grade dollar strength as a mild positive for Small Caps, but not enough to outweigh other factors that continue to point to Large Cap strength (including relative valuations, looming Fed tightening, and the continued narrowing of market breadth related to bull market age).