Does big cap lead small cap in market euphoria, or vice versa? UBS

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Does big cap lead small cap in market
euphoria, or vice versa?
On 11 October, we published a note reiterating our liquidity thesis, and flagged
the possibility that some Asian markets could be entering early stages of
potential euphoria (Monetary “Pass the Parcel”). Subsequently we have
received questions on what performs the best in euphoric markets, and whether
large cap or small cap leads the way.
In Charts 9 and 10 below, we show the relative performance of MSCI Asia ex
Japan Large vs. Small Cap indices during the dot-com bubble and before 2007.
When the shaded area is above the horizontal line, large cap outperforms in the
previous month, and vice versa. In both periods, small cap outperformed in
earlier phases of the bull market, but large cap outperformed in the final legs of
the run.


We have also re-run our analysis in Monetary “Pass the Parcel” on how
individual Asian country markets have performed during market euphoria. Out
of the 33 episodes we have identified over the last 35 years, we have data on
large vs. small cap performance for 13 of them. Whilst on average small cap
outperformed during the euphoric periods, the gap shrinks the closer we get
towards the market peak (Table 5).
Could the mega-cap stocks be responsible for the better relative performance for
the large cap index during late stage bull markets? We have run the analysis for
the 3 stocks with the largest market cap and find that they outperformed small
cap throughout the bull market period on average, though the outperformance
actually shrinks the closer we get to towards the peak. We would caution
against extrapolating too much from this data because the average is distorted by
outliers amongst the episodes.


The data above seems to contradict the popular belief that small cap outperforms
in late bull markets. We suspect that small cap stocks tend to deliver higher
‘beta’ in an upward trending market leading up to an euphoria, and some small
cap stocks do deliver headline-grabbing performance in the late stage bull
markets.
However, as the market reaches an exuberant mood it attracts an increasing
amount of funds that are less interested in outperforming a rising market than
simply participating in the market moves. Those funds are more likely to be
invested in big cap ‘index’ stocks rather than small cap. Hence in aggregate the
large cap relative performance improves.