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This year has given investors plenty of surprises. Notably, after stocks bottomed in late March, categories that traditionally lead in a new bull market haven’t necessarily done so in 2020. Since historical market data have become widely available, more investors have tried to identify patterns -- such as when a company’s size or stock style tends to drive outperformance. A widely observed historical pattern is that small-capitalization and value stocks often outperform in the initial stages of a new bull market.

However, small-cap and value categories haven’t taken leadership so far in this year’s new bull market. While investors focusing on historical data alone may be scratching their heads, historical patterns should be viewed as guidelines rather than hard-and-fast rules. Fisher Investments believes the sharp market drop and recovery have acted more like a massive correction than a traditional bear market, resulting in a fundamental backdrop that still favors large-cap growth stocks and lacks the traditional, lasting shift in style leadership. In this article, we’ll discuss investors’ expectations for small-cap and value stocks to lead early in bull markets and why that may not happen this time.

Small-Cap and Value Stocks Historically Lead in Recoveries

One reason small-cap companies and value companies (which tend to be more economically sensitive and carry higher debt loads than larger, growth-oriented companies) lead early in a bull market is because they tend to fall the most during a downturn and therefore bounce the most in a subsequent recovery.

In a bear market -- a fundamentally driven downturn of 20% or more -- investors fear cyclical, value companies and/or small-cap companies may not be able to weather the downturn and so they disproportionately sell off their shares relative to what’s really warranted by economic conditions. Though some firms fail in bear markets or recessions, once a new bull market begins, those fears often prove overly pessimistic, driving small-value stocks to rebound more than other categories as bankruptcy concerns fade and stocks price in a brighter future ahead.

Another reason small-value stocks often lead early in bull markets is due to improving credit conditions. In the recovery stage after a recession, short-term rates tend to fall more than long-term rates, as central banks traditionally cut policy rates to spur economic growth. This steepens the yield curve -- the difference between long-term and short-term interest rates -- which is a good proxy for bank profitability and incentivizes lending growth. Expectations of improved credit availability disproportionately benefit cyclical and often less-creditworthy firms, which helps boost small-value stocks.

But we may not get that kind of small-value leadership this year for a few fundamental reasons.

History’s Fastest Bear may add a new Twist

Fisher Investments believes one reason value and small-cap stocks haven’t consistently led this year is because the bear market’s correction-like speed likely mitigated the late-stage small-value selloff that typically sets up their early bull market surge.

While small-value categories tend to lead after traditional bear markets, that’s not the case following bull market corrections -- short, fear-driven market drops of about 10% to 20% that occur during bull markets. After corrections, category leaders before the drop often resume leadership during the recovery. While this year’s downturn was a bear market by magnitude, it was correction-like in duration. To demonstrate this, Exhibit 1 below shows this year’s downturn against the median correction and bear market. 

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A Correction-like Bear Market

Fisher 101520 Exhibit 1 correction

So far, this year’s bear market and new bull market haven’t featured a significant style-leadership rotation typically seen after a bear market. Exhibit 2 below shows the performance on the drop and recovery for various styles of stocks, including value, growth, small-cap and large-cap stocks, as well as stocks in the Technology sector.

In the downturn, value and small-cap stocks got hit the hardest. But on the recovery from March 23 to Aug. 31, small-cap stocks bounced significantly and rivaled large-caps, while value badly lagged growth. Further, technology stocks -- predominantly growth stocks by nature -- have outperformed all categories.

The Bounce in Detail

Fisher 101520 Exhibit 2 bounce

Another fundamental driver Fisher Investments believes is stymieing value and small-cap stocks’ run in the new bull market is a relatively flat yield curve. This is due, in part, to central banks’ quantitative easing (QE) programs, in which central banks purchase long-term bonds, keeping a lid on long-term rates, flattening the yield curve and potentially reducing banks’ profitability on new loans. As the economy improves, inflation expectations may rise, driving long-term rates higher and steepening the yield curve, which may benefit value stocks. But we believe QE’s disinflationary nature and recently waning velocity of money should keep a lid on long-term interest rates, preventing the bank-based credit boost small-cap and value firms need to outperform the rest of the market for any meaningful amount of time.

Growth and large-cap stocks seem to have resumed leadership in the recovery partly because of the nature of the lockdowns as well. The COVID-19 pandemic increased demand for work-from-home solutions, e-commerce services and digital-streaming services, which largely favor large-cap and growth (primarily technology or tech-like) stocks.

This isn’t to say value and small-cap stocks will never outperform -- they might. But investing based solely on what historically happens is dangerous -- you must also study the market environment and assess for nuance. Given the current fundamental backdrop and unique characteristics of this year’s bear market, Fisher Investments believes a sustained, early-bull shift toward small-value stocks is unlikely and, instead, large-cap and growth stocks should continue leading for the foreseeable future.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.