How will the large and small cap styles perform at the end of the year?

Report Summary

1. In the 50 years of the U.S. stock market, how is the rotation and intensity of large and small cap styles characterized? We constructed a large and small cap style rotation index based on individual stocks: in annual statistics, 27% of the years exhibited small cap style, while 73% showed large cap style; in monthly statistics, 37% of the months exhibited small cap style, and 63% showed large cap style. The small cap style is primarily concentrated in two periods: the late 1970s to early 1980s and the early 2000s. Over the past 20 years, large cap stocks in the U.S. stock market have consistently outperformed, and under the rolling 12-month dimension, there has been no instance of small cap stocks outperforming.

1. In the 50 years of the U.S. stock market, how is the small cap style formed: three characteristics and two scenarios.

(1) The small cap style in the U.S. stock market mostly appears in the [late stage of economic recession or early stage of recovery].

(2) The small cap style in the U.S. stock market mostly appears in the [end of interest rate cuts -> before interest rate hikes].

(3) In small cap markets, the leading industries are mainly those that are oversold or in a prosperous state.

(4) There are two scenarios for the excess performance of small cap stocks: one is the low base effect after an event crisis (lasting from six months to one year): recovery from relatively poor performance, with small cap stocks having greater earnings recovery elasticity. The second is industrial transformation during turbulent times (lasting from 2 to 5 years): driven by policy or industrial environment catalyzed incremental economy, such as computers and semiconductors in the mid to late 1970s in the U.S.; real estate after the burst of the dot-com bubble in 2000.

1. Style rotation is the result of profit differentiation and convergence. The large and small cap market reflects changes in the macro environment or industry structure that lead to relative performance changes. The annual fluctuations in the U.S. stock market largely depend on the growth rate of net profits; the rhythm of large and small cap style rotation is also consistent with the relative direction of earnings changes. A detailed review of five instances of small cap style (see main text).


How to view the style rotation of the current A-shares?

1. A sustained small-cap stock market generally appears at the end of an economic recession or the early stage of recovery. For the small-cap style, liquidity is a key catalytic factor (the interest rate cut cycle continues to release ample liquidity), but the premise is that profits do not further deteriorate (the macro cycle has a bottom).

2. In the key meeting next week, we expect a higher probability of a relatively positive policy stance, and the market style may temporarily shift towards balance, for example, the cyclical blue chips that have stagnated in the past two months may see their central tendency rise. However, considering that the period before the second quarter of next year is relatively a vacuum for macro data, it is difficult to verify or falsify the strength of economic recovery, and the market style may fluctuate, but thematic trends and small-cap trends may still dominate.

3. Looking ahead, if either of the following two scenarios occurs, the style may significantly shift towards large-cap:

First, there is an expectation of a renewed weakening in the fundamentals. If the official target deficit rate for 2025 remains at 3.0%, or if during the "April Decision" in 2025, the broad fiscal stimulus is indeed weak, then the market style may return to defensive allocations such as dividend assets and large-cap state-owned enterprises, at which point the large-cap style will be relatively dominant, as seen in the first three quarters of 2023-2024.

Second, there is an expectation of a significant upward movement in the fundamentals. If the official target deficit rate for 2025 reaches 4.0% or higher, and during the "April Decision" in 2025, the extent of broad fiscal expansion is indeed sufficiently obvious (an increase of more than 5% of nominal GDP), while the macro fundamentals show significant recovery elasticity, then cyclical blue chips are likely to lead the market, and the large-cap style will also dominate, as seen in 2020.

Report Body

Recently, whether in the A-share small and large-cap styles or the U.S. stock small and large-cap styles, the performances have been quite extreme. Discussions about style "turning points" have also increased. In this regard, we reviewed some patterns of style rotation in the U.S. stock market over the past 50 years and looked ahead to the possible current market trends

I. 50 Years of U.S. Stocks: How to Characterize the Rotation and Intensity of Large and Small Cap Styles

The description of large and small cap styles can be illustrated using the large and small cap style indices (Russell 1000/Russell 2000, with indices starting from 1979), or by grouping market capitalization and then calculating the gains to observe the monotonicity of market capitalization.

To more intuitively represent the rotation and intensity of large and small cap styles in the U.S. stock market over the past 50 years, and to obtain a longer historical series, we constructed a large and small cap style rotation index based on individual stocks. The specific method is as follows:

(1) All market stocks (excluding the bottom 10% by market capitalization) are divided into 10 groups based on market capitalization at the beginning of the month, with the 1st group being the largest and the 10th group being the smallest;

(2) The median monthly gain for each group is calculated, and the gains of the 10 groups are standardized using z-scores;

(3) The standardized gains of groups 1 to 10 are multiplied by {5, 4, 3, 2, 1, -1, -2, -3, -4, 5} respectively, and then summed up, resulting in the large and small cap style rotation index.

From the logic of index construction, we can deduce:

(1) Values above 0 indicate an advantage for large cap stocks, with larger values indicating stronger large cap stocks;

(2) Values below 0 indicate an advantage for small cap stocks, with smaller values indicating stronger small cap stocks;

(3) A narrowing of positive or negative values indicates a convergence in the dominance of large or small caps, but does not imply a reversal of styles.

It can be observed that over the past 50 years, the U.S. stock market has mostly exhibited a large cap stock style: in annual statistics, 27% of the years showed a small cap style, while 73% exhibited a large cap style; in monthly statistics, 37% of the months showed a small cap style, while 63% exhibited a large cap style.

The small cap style was notably concentrated in the late 1970s to early 1980s, as well as in the early 2000s. In the past 20 years, large cap stocks have consistently dominated the U.S. stock market, and under a rolling 12-month dimension, there has been no occurrence of small cap stocks dominating, currently reflecting a strong large cap stock style

II. 50 Years of U.S. Stocks: How Small-Cap Style Has Evolved

(1) How Small-Cap Style Forms: Three Characteristics, Two Scenarios

From the data analysis in the first part, it can be seen that there have been a total of 5 relatively sustained small-cap stock markets in U.S. history.

Three of these small-cap markets were strong, occurring from: the mid-1970s to the early 1980s, early 1992 to early 1994, and early 2001 to early 2004;

Two of these small-cap markets were weaker, occurring in: the first half of 2009 and the second half of 2020 to early 2021.

In summary, small-cap stock style has several characteristics:

(1) The small-cap style in U.S. stocks mostly appears in the [late stages of economic recession or early stages of recovery].

Before the formation of the small-cap stock style, the U.S. macro economy had experienced a recession phase. Among these, the longest duration of small-cap stocks was from the mid-1970s to the early 1980s, during which there were three economic recessions.

The starting point for the small-cap style generally occurs in the late stages of economic recession or early stages of recovery, that is, around the economic bottoming phase.

We understand that the main reason behind this is: during the formation of economic recovery expectations, the market will first look for directions with greater elasticity. At this time, small-cap stocks are severely damaged during the economic downturn and recession cycle, and due to the low base effect, in the first half of the recovery, the upward elasticity of profits is greater. When the base effect weakens, the market returns to true economic pricing, and the small-cap style weakens.

(2) The small-cap style in the U.S. stock market mostly appears at the end of interest rate cuts before interest rate hikes.

In the five instances of small-cap stock styles, they all formed in the mid to late stages of interest rate cuts and lasted until before interest rate hikes. For example, at the end of 2008, when interest rates dropped to 0, a sustained small-cap market began in early 2009; the interest rate cut cycle that started in mid-1989 continued until the second half of 1992, during which a sustained small-cap market began in early 1992.

For the small-cap style, liquidity is a key catalytic factor (the interest rate cut cycle continues to release ample liquidity), but the premise is that profits do not further deteriorate (the macro cycle has a bottom).

(3) In a small-cap market, the leading industries are mainly those that have been oversold or are in a prosperous state.

In the past five small-cap stock markets, the leading industries were mostly those that had been oversold, such as the energy and finance sectors leading in the second half of 2020, and the technology and materials sectors leading in the first half of 2009, both of which had factors of oversold rebounds; additionally, there were also increases driven by prosperity, such as real estate in 1992-1994 and 2001-2004.

(4) Finally, there are two scenarios for the excess performance of small-cap stocks:

One is the low base effect after an event crisis (lasting six months to one year): The underlying reason is the recovery of relatively poor performance, mainly existing for a period after an event crisis, where small-cap stock profit recovery has greater elasticity, and at this time, there is generally also an overlapping effect of liquidity surplus after monetary easing.

The second is the background of industrial transformation in turbulent times (lasting 2 to 5 years): This comes from incremental economic growth catalyzed by policy and industrial environment, with the background being a long period of economic stagnation, where policies begin to seek structural transformation, such as the rapid rise of computers and semiconductors in the mid to late 1970s in the U.S.; after the burst of the tech bubble in 2000, policies shifted to stimulate real estate. The result is: large-cap blue chips, which are highly correlated with the macro economy, are sluggish; while the performance of emerging industries representing incremental economic directions is relatively prominent, often led by small-cap thematic markets.


(2) Style rotation is the result of profit differentiation and convergence

To summarize the previous text, over the past 50 years in the U.S. stock market, there have been two scenarios behind the formation of small-cap style five times—low base effect and emerging industry catalysis. The performance of large and small caps reflects changes in the macro environment or industry structure that lead to relative performance variations.

First, from the perspective of the factors determining short-term market fluctuations, similar to the conclusions drawn from the A-share market, the magnitude of short-term (1-year dimension) fluctuations in the U.S. stock market largely depends on the growth rate of net profit.

For the entire U.S. stock market, using annual data from 1981 to 2023: ① Grouping annual net profit growth rates into 10 groups, from the 1st group (highest growth rate) to the 10th group (lowest growth rate); ② Then, calculating the median annual increase for each group.

The data shows that the annual fluctuations have a good monotonic positive correlation with the annual net profit growth rate, and this characteristic has been quite evident across historical years, indicating that the pattern has cyclical characteristics.

Secondly, the style rotation stems from relative changes in profits. As shown in the figure below, the ratio of stock prices A to B (red line) follows the change in the growth rate difference between A and B (gray bars). Additionally, since 2012, the style rotation represented by Russell 2000 and Russell 1000 (coefficient ratio) has also shown a similar directional change with relative performance variation (EPS growth rate difference).

(3) Detailed review of the five small-cap styles Next, we will review in detail the formation process of small-cap stocks over the past five instances.

The first instance of small-cap stock style: formed during the period of stagflation from the mid-1970s to the early 1980s, this is the longest-lasting and most well-known small-cap market in the history of U.S. stocks. The catalyst for the small-cap market came from industrial transformation in a turbulent environment and the rapid rise of emerging technologies.

From January 1975 to June 1983, there were also phase rotations between small-cap and large-cap styles, with 54% of the months exhibiting small-cap style and 46% exhibiting large-cap style; during this period, the leading sectors were: real estate, technology, and finance, which included both the direction of a rebound from oversold conditions (real estate) and the direction of industrial trends (technology).

Specifically, the reasons for the prolonged duration of this round of small-cap style are mainly as follows:

(1) Repeated economic stagflation. The U.S. economy began to suffer from the impact of recession in 1969 (after a long period of tax cuts and fiscal expansion, inflation rose, and monetary policy began to tighten), and this continued until the early 1980s, with the U.S. experiencing alternating periods of prosperity and recession (interest rate cuts dragging the economy vs. interest rate hikes combating inflation).

Several wars during this period caused a significant rise in oil prices: the Vietnam War continued until the early 1970s, the fourth Middle East war in 1973 (the first oil crisis), the Iranian Revolution in 1979 (the second oil crisis), and the Iran-Iraq War from 1980 to 1988.

(2) Large-cap assets such as the "Nifty Fifty" did not exit the valuation-killing phase. After the decline in 1973-1974, the valuation of the Nifty Fifty fell from 43 times to around 20 times, while government bond yields continued to rise, and profits were marginally weakening. As core large-cap assets, the Nifty Fifty had not yet exited the valuation-killing phase.

(3) The emergence of new technologies and new industries brought new conceptual hotspots. The 1970s saw a leap in the development of integrated circuits and microcomputers, with several tech stars being established during that time. For example, Microsoft was founded in 1975, Apple in 1976, Oracle in 1977, Micron in 1978, and RAM Research in 1980 (4) Research and development expenditures are experiencing high growth against the trend, as the market transitions from a stock economy to a flow economy. The 1970s was a period when the U.S. economy shifted from manufacturing to mass consumption and emerging technologies. During a phase of continuous economic slowdown, overall research expenditures continued to grow significantly: from 1973 to 1980, GDP growth rate fell from 5.6% to -0.3%, but the growth rate of R&D expenditures in computers and electronics rose from 10.2% to 21.5%.

During the "Nifty Fifty" phase, everyone embraced core assets with high certainty, which essentially represented a risk-averse behavior within the stock economy. The emergence of the technology revolution led people to seek small and mid-cap companies that were in the initial stages of the flow economy and represented future directions. At this time, against the backdrop of economic downturn, high interest rates, and overvalued core assets, funds may be more willing to explore new industrial directions to achieve higher expected investment returns.

(5) As emerging industries gradually take shape and relevant technology leaders go public, inflation is controlled, the economy is back on track, and the valuation of the "Nifty Fifty" undergoes a deep adjustment, the small-cap style that has persisted for several years shifts back to a large-cap style. In 1981, Reagan implemented the "Economic Recovery Plan," which included significant tax cuts, reductions in government spending, control of the money supply, and deregulation of businesses; at the same time, Federal Reserve Chairman Volcker insisted on adopting a tight monetary policy to curb inflation, which peaked in 1981 for both inflation and interest rates.

Additionally, we see that companies representing the direction of the emerging economy also concentrated their listings, such as AT&T in 1983, Lam Research in 1984, Micron in 1984, Microsoft in 1986, Adobe in 1986, and Oracle in 1986. The market style shifted again towards the "Nifty Fifty," which had undergone a prolonged valuation adjustment.

In summary: The main reasons for the sustained small-cap style from the mid-1970s to the early 1980s, lasting for 9 years, were long-term ultra-high interest rates (leading to the devaluation of core assets) and the technology industry revolution (bringing opportunities in the flow economy and catalyzing thematic market trends).

After inflation is controlled, the economy is back on track, and valuations undergo deep adjustments, the large-cap blue chips represented by the "Nifty Fifty" also gain long-term value-added space driven by profits. Additionally, the technology leaders emerging from the technology industry revolution gradually grow into a new "Nifty Fifty."

The second small-cap style: early 1992 to early 1994, lasting more than 2 years, against the backdrop of the end of a recession + the start of an interest rate cut cycle + initial stabilization of fundamentals.

The turbulent environment in the early 1990s caused the macro economy to fall into recession: the third oil crisis in 1990, the Gulf War in 1991, and the European currency crisis in 1992 At the end of 1990, the interest rate cut cycle began, and in 1992, the macroeconomic fundamentals stabilized, ushering in a small-cap stock market. It is worth mentioning that this period entered a stunning decade of high growth and low inflation.

From January 1992 to February 1994, there were also phase rotations between large-cap and small-cap styles, with 58% of the months showing small-cap style and 44% showing large-cap style; during this period, the leading industries were: real estate, technology, and industrials, mainly supported by fundamentals or industrial trends.

The third small-cap style: from early 2001 to early 2004, lasted for 3 years, against the backdrop of economic recession + the beginning of the interest rate cut cycle + policy shift to stimulate real estate and consumption.

The background of this small-cap style was the significant reversal of U.S. monetary policy and the shift in economic policy to stimulate real estate and consumption after the tech bubble burst in early 2001.

In the second quarter of 2000, the U.S. economy began to decline sharply, with PMI data continuously falling and dropping below the boom-bust line in July. Subsequently, scandals such as the Enron and WorldCom financial frauds, along with crises like the "911" incident, the Afghanistan War, and the Iraq War, cast a shadow over the market and spread panic. The U.S. economy also fell into a prolonged recession, with GDP growth rate once dropping into negative territory. To stimulate the economy, the Federal Reserve began a series of 13 interest rate cuts starting in January 2001, reducing the rate from 6.5% to 1.0%, which greatly stimulated the development of the real estate market and credit consumption.

During this process, as liquidity was significantly loosened, the small-cap market gradually emerged, with the leading industries being real estate and raw materials stimulated by the low-interest-rate environment.

This phase also exhibited the most sustained small-cap market since the 1980s. Due to the relatively sluggish macroeconomic performance, large-cap blue chips overall lacked upward elasticity. From the monthly data, during this period, 62% of the months showed small-cap style and 38% showed large-cap style.


The 4th Small-Cap Stock Style: In the first half of 2009, lasting for six months, the background was the collapse of the subprime bubble, interest rates dropped to 0, and quantitative easing (QE) was implemented, with expectations of economic stabilization.

The subprime crisis of 2008 was the most severe and widespread global financial crisis since the Great Depression. From the perspective of the causes of the crisis, the market rescue measures in 2000 laid the groundwork for the subprime crisis in 2008. From June 2004 to August 2006, the Federal Reserve raised interest rates 17 times in a row, with rates increasing from 1% to 5.25%. The continuous tightening of monetary policy began to impact the market in the second half of 2006, with housing prices starting to loosen and the risk of mortgage defaults significantly increasing, exposing the risks of financial products such as MBS/ABS/CDS/CDO. After entering 2008, the subprime crisis further evolved into a global financial crisis.

In response to the crisis, the Federal Reserve's monetary policy shifted dramatically. From September 2007 to December 2008, the Federal Reserve cut interest rates 10 times in a row, bringing the lower limit to 0, while innovatively using various monetary policy tools to release short-term liquidity. Starting in November 2008, it initiated three rounds of QE, purchasing large amounts of government bonds and MBS, lowering long-term interest rates to promote corporate investment and household consumption, stimulating economic recovery. The small-cap market began to unfold against the backdrop of significant liquidity easing and expectations of macroeconomic stabilization.

During this process, the leading sectors were mainly the previously oversold technology, basic materials, and financial sectors.

The 5th Small-Cap Stock Style: From the second half of 2020 to early 2021, lasting for six months, the background was after the COVID-19 pandemic, the Federal Reserve again lowered interest rates to zero and initiated unlimited QE after the collapse of the subprime bubble and economic downturn, with monetary policy shifting to significant easing.

In March 2020, the Federal Reserve conducted two emergency operations to cut interest rates to zero, marking the second implementation of a zero interest rate policy by the Federal Reserve after the 2008 financial crisis, and initiated unprecedented unlimited monetary easing, providing unlimited liquidity to the market The U.S. stock market began a "V" shaped recovery in April 2020, while the small-cap stock rally only started to unfold when there were clear signs of fundamental improvement in the third quarter (manufacturing PMI returned to the boom-bust line and continued to rise). Essentially, this was driven by the recovery of a damaged economy and the oversold rebound of related industries, combined with an environment of excess liquidity, which gave small-cap stocks stronger price elasticity.

During this process, the leading sectors were mainly the previously oversold energy and financial sectors.

III. How to View the Current Style Rotation in A-shares

From the past 50 years of small-cap and large-cap rotation patterns in the U.S., it can be seen that sustained small-cap rallies generally occur at the end of economic recessions or the early stages of recovery; for the small-cap style, liquidity is a key catalytic factor (the interest rate cut cycle continues to release ample liquidity), but the premise is that profits do not further deteriorate (the macro cycle has a bottom); if there is a direction for emerging industry transformation, the duration of the small-cap style may be longer.

From the historical performance of A-shares, 2016 was a turning point year for styles. Before that, small-caps generally outperformed, and after that, large-caps took the lead. We believe the possible reasons lie in the significant ups and downs of the macro environment in the past:

(1) Small-cap outperformance: In the 1990s and 2000s, the domestic economy continued to grow rapidly, and in this overall incremental economic environment, small and medium-sized companies had sustained growth space.

(2) Extreme small-cap: Since 2010, as economic growth slowed down, economic structural transformation and emerging industry policies also drove the small-cap rally to gradually reach extremes from 2013 to 2015.

(3) Large-cap outperformance: 2016 was a turning point year for styles, after which the market entered an era of stock economy dominated by supply-side reform and deleveraging, with large-cap blue-chip styles continuously prevailing.

(4) Small-cap phase outperformance: Entering 2021, the market briefly switched to a small-cap style, lasting about six months, supported by the combination of two scenarios: first, after the crisis mode of the global pandemic, small-cap stocks had greater performance elasticity due to the low base effect; second, against the backdrop of the energy revolution and domestic substitution, policies and industry cycles jointly drove high growth in the "hard technology" sector.

(5) Balanced small and large-cap styles: After 2021, the relative advantages of small and large-cap styles entered a narrow range of fluctuations. It can be seen that in the past decade or so, relatively sustained small-cap rallies occurred during the periods of 2009-2010 and 2013-2015. Since 2018, styles have switched back and forth, with no obvious trend; during this period, there were also brief instances of small-cap style dominance from February to August 2021 and since October 2024, characterized by significant liquidity easing and expectations of macroeconomic stabilization or beginning to warm up

Currently, expectations for fiscal stimulus are strengthening, and market styles may phase into a more balanced state. Considering that there is a relative vacuum period for macro data until the second quarter of next year, it is difficult to verify or falsify the strength of economic recovery. Market styles may fluctuate, but thematic trends and small-cap trends may still dominate.

Looking ahead, if either of the following two scenarios occurs, small-cap styles may significantly shift towards large-cap styles:

First, there is an expectation of a renewed weakening in the fundamentals. If the official target deficit rate for 2025 remains at 3.0%, or if during the "April Decision" in 2025, the broad fiscal stimulus is indeed weak, then market styles are likely to revert to defensive allocations such as dividend assets and large state-owned enterprises, at which point large-cap styles will relatively dominate, similar to the first three quarters of 2023-2024.

Second, there is an expectation of a substantial upward movement in the fundamentals. If the official target deficit rate for 2025 reaches 4.0% or higher, and during the "April Decision" in 2025, the extent of broad fiscal expansion is indeed significantly evident (with an increase accounting for over 5% of nominal GDP), accompanied by a notable recovery elasticity in the macro fundamentals, then cyclical blue chips are likely to lead the market, and large-cap styles will also dominate, as seen in 2020.

Finally, the most favorable macro combination for large-cap blue chips is "moderate growth + moderate inflation." This is the ideal combination, where performance grows steadily without concerns of rapid policy tightening. After the 1980s, U.S. stocks have shown a continuous large-cap stock trend in most years. For example, from 1984-1991, 1994-2000, 2004-2008, and from 2010 to the present. As long as the economy grows moderately and ROE maintains a stable fluctuation state, large-cap blue chips are the direction with a higher win rate.


Author of this article: Liu Chenming/Zheng Kai/Li Rujuan, Source: Chenming's Strategic Deep Thinking, Original Title: "How Will the Style of Large and Small Caps Play Out at Year-End? [Guangfa Strategy Liu Chenming & Li Rujuan]"

Analysts:

Liu Chenming: SAC Certification No.: S0260524020001

Zheng Kai: SAC Certification No.: S0260515090004

Li Rujuan: SAC Certification No.: S0260524030002

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