» When U.S. interest rates decline, U.S. small-cap stocks have historically outperformed large-cap stocks.

» A steep yield curve has historically led to U.S. small-cap outperformance, while yield curve inversions have been more favorable toward large-cap stocks.

The U.S. Federal Reserve began raising interest rates in early 2022, making 11 rate hikes between March 2022 and July 2023. After entering a “Fed pause” for over a year, the Federal Reserve reduced the fed funds rate by 0.50% at its September 2024 meeting. This was the first interest rate cut since March 2020. As shown in Exhibit 1, during this rate hike cycle, U.S. large-cap stocks significantly outperformed small-cap stocks.

Given the shift in Fed policy, this research investigates how U.S. small-cap stocks have historically performed compared to large-cap stocks in different interest rate environments, specifically periods of rising and falling rates. In addition, we also reviewed periods when the yield curve is inverted (short-term rates above long-term rates) or upward-sloping (short-term rates below long-term rates).

To analyze the performance of small-cap stocks compared to large-cap stocks, we utilized the Fama-French Small Minus Big (SMB) factor returns. These are calculated by dividing all stocks listed on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and the Nasdaq into two groups based on market capitalization (small and large), and then subtracting the average return of the small-cap portfolio from the average return of the large-cap portfolio.

This equal-weighted factor has some benefits over market-cap-weighted indexes like the S&P 500 Index and S&P SmallCap 600 Index. Market cap-weighted indexes allow larger companies to hold significantly more weight, potentially skewing the overall index returns.

We can analyze the recent impact of the Magnificent 7 stocks on the S&P 500’s performance as an example.* As shown in Exhibit 2, from January 2019–July 2024, the S&P 500 Index outperformed the S&P 600 by 5.5%. During the same period, the Magnificent 7 stocks gained 32.5%. By excluding these 7 stocks from the index, the S&P 500 annualized return drops to 12.1%, only outperforming the S&P 600 by 0.5%. By using the Fama-French Small Minus Big (SMB) factor, we minimize the impact of periods like this on the research.

For our study, we used data from January 1954 through July 2024. We determined the interest rate environment by using the 3-month U.S. Treasury rate. We calculated the 3-month change of this interest rate and measured the performance of U.S. small-cap and large-cap stocks when the change in 3-month U.S. Treasury rates was negative and positive. Remember, when the return of the Small Minus Big (SMB) factor was positive, small-cap stocks outperformed large-cap stocks. When it was negative, large-cap stocks outperformed small-cap stocks.

As Exhibit 3 demonstrates, when interest rates declined, forward returns of small-cap stocks were greater than large-cap stocks. When interest rates increased during the previous three months, the forward returns for small-cap stocks were lower than large-cap returns.

1954 to 2024 is a very long period, which includes several different market environments. To identify whether this relationship was more prevalent in different periods than others, we divided history into four periods, highlighted in the chart below. There are two periods when small-caps outperformed large-caps (1954–1983 and 1999–2011) and two periods when large-caps outperformed small-caps (1983–1999 and 2011–July 2024).

As shown in Exhibit 5, we observed a similar pattern in all four periods. Declines in interest rates were more beneficial for small cap’s relative performance than increases in interest rates. During the periods of January 1984–March 1999 and August 2011–July 2024, small-caps underperformed large-caps whether rates were declining or increasing. Even under these circumstances, negative changes in interest rates were more favorable for small-cap stocks than positive changes.

The recent steepening of the U.S. yield curve marks the end of a record-long yield curve inversion. As the Fed reduces short-term rates, the yield curve may steepen further, leading to a question. Does a steepening yield curve impact the performance of small- and large-cap stocks?

We used the 3-month U.S. treasury bill and the 10-year U.S. treasury bond to define the yield curve. As shown in Exhibit 6, we researched the performance of the small-minus-big factor (SMB) during three scenarios: an inverted yield curve, a moderately steep yield curve, and a very steep yield curve.

History shows that during an inverted yield curve, large-cap stocks outperformed small-caps. While a moderately steep yield curve did not indicate a significant difference in performance for small- and large-cap stocks, a very steep yield curve favored small-cap stocks.

Reviewing the same four periods we used previously, the impact of the yield curve on small- vs large-cap performance is quite consistent. A very steep yield curve has been more beneficial to small-cap’s relative performance than when it is inverted.

History indicates that declining short-term rates have generally been favorable for U.S. small-cap stock returns relative to large-cap stocks. In addition, while an inverted curve has been more favorable for large-cap stocks, an upward sloping yield curve has historically favored small-cap stocks.

Why might this be the case? One reason may be related to company debt. Lower interest rates help small-cap companies reduce interest expenses on new debt and directly lower the cost of their floating-rate debt. Small-cap companies traditionally have weaker balance sheets relative to large-cap companies, so higher debt costs can be especially impactful.

With that being said, the last decade of below-average interest rates have been dominated by large-cap companies investing in e-commerce, new technology, and artificial intelligence. However, when we analyze the performance of stocks by removing the market capitalization bias, small-cap stocks performed better during declining rate environments than rising rate environments. In addition, a positive sloped yield curve often signals optimism about future economic growth. Small-cap companies tend to be more sensitive to economic cycles than large-caps, benefiting more from positive expectations of economic growth.

So, there might be structural changes in the market that can favor either small- or large-cap stocks over a long period, but within these periods the evolving interest rate environment provides opportunities to investors in short- to medium-term to tactically shift assets to small- or large-cap stocks based on the rate environment.

Commentary offered for informational and educational purposes only. Opinions and forecasts regarding markets, securities, products, portfolios, or holdings are given as of the date provided and are subject to change at any time. No offer to sell, solicitation, or recommendation of any security or investment product is intended. Certain information and data has been supplied by unaffiliated third parties as indicated. Although Meeder believes the information is reliable, it cannot warrant the accuracy, timeliness or suitability of the information or materials offered by third parties.

Investment advisory services provided by Meeder Asset Management, Inc.

©2024 Meeder Investment Management, Inc.

0274-MAM-10/28/24-46005