What's Ahead for Small-Cap Stocks?

NEW YORK (TheStreet) -- Four years into the current bull, with sentiment waffling between skeptical and optimistic, it seems we're at least past the halfway point -- typically large-cap stocks' time to shine. Yet, small-caps have had a nice run lately, prompting many investors to ask: Will this countertrend rally stay, or will big stocks soon regain leadership?

We expect the world's largest companies -- mega-cap stocks -- to perform better, on average, over the remainder of the bull market. In our opinion, this is largely tied to the yield curve and investor behavior in this maturing expansion.

You can thank the Federal Reserve for this. Typically, small firms perform best when the yield curve is steep and bank credit is, as a result, plentiful. Many small firms rely on bank lines of credit to finance new equipment, software, facilities, hiring and the like, all of which supports growth.

However, the Fed's successive rounds of quantitative easing have flattened the yield curve, sapping banks' appetite for lending. The yield curve, the difference between long and short rates, represents a bank's potential profit on the next loan made (i.e., banks borrow short to lend long).

When the curve's flat, potential profits are small, and banks have less incentive to lend. Then, small firms -- often viewed by banks as riskier investments -- are often squeezed out of lending markets. That makes growth difficult, limiting shareholders' potential upside.

In addition, since late 2008 the Fed has been paying banks a competitive rate to park excess reserves, giving banks still less incentive to lend as aggressively. This likely impacts upon smaller firms disproportionately.

Large companies typically fare better relatively when the yield curve's flat. Not only do they frequently have a relatively easier time securing bank financing, but they can also more easily tap corporate debt markets, where interest rates are near generational lows.

It's a significant advantage for these larger firms in a maturing expansion, and the Fed has signaled QE won't end any time soon. Policymakers have pledged to stay "accommodative" until unemployment falls to 6.5% and inflation ticks up to 2.5%. With unemployment at 7.7% and improving slowly, monthly asset purchases of $85 billion seem set to continue indefinitely, keeping long rates down and the yield curve flat.

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