A BIG Year

Story Highlights:

• Large cap stocks are beating small caps for the first time in the current bull market, inciting many analysts to forecast a new era of large cap dominance.
• Trends are fickle things, and there are few good reasons to believe big cap dominance is a foregone conclusion.
• If you do make a bet on big, make sure you don't choose stocks that seem big but are really small.

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Some of us learned it sitting alone at prom's end after the football captain stole our best gal. Others of us learned it coming home from school one fateful day to find that Astro, our canine best friend, had been sent "off to live in the country." Still others learned it a bit more awkwardly, sticking with those Disco era feathered hairdos well into the 90s.

Love…pets…fashion trends…nothing lasts forever. And so too it is with stocks. No category of stocks outperforms for all time. Sometimes value stocks lead, others growth; sometimes US stocks beat foreign, and sometimes the opposite. The current bull market, incepted early 2003, has been an era of fairly consistent trends. For instance, non-US stocks have thumped US stocks consistently in recent years.

But one trend seems to be breaking down. Small caps have beaten large caps fairly soundly for some time, but not in 2007, which looks to be the big cap coming out party. Big is beating small this year over just about all categories—agnostic to style and region.

Year-to-date, the Russell 2000 Index (a common measure for US small cap stocks) is down about -1.5% versus the S&P 500's return of 6.2%. Which is a decent spread, but if we look at small versus big in a slightly different way, the dispersion gets even wider.

Many folks have a tough time with what really constitutes small and big. Sure, we know Exxon, with its $480 billion market cap is hefty, but what about Ebay, which has a $45 billion market cap? Is that big too?

Actually, no. We think the proper way to look at size is to find the weighted average market cap of whatever universe of stocks being examined and make that the mid-point. For the MSCI World index (a common measure of stocks in developed countries) the current weighted average market cap is in the +$75 billion range. That means anything below $75 billion is small, and anything higher is big. In this case, Ebay's measly $45 billion is pretty darn small.

Why look at it that way? It might seem dumb at first because it puts the vast majority of stocks into the small category, and a relative few in the big category. We do it because stocks smaller than the weighted average market cap, even if they seem big, tend to perform more like small caps. Only the super-big guys really behave differently.

Looking at how stocks have done on this basis in 2007, the dispersion is even bigger. MSCI World super caps are up over 23%, while the MSCI World index as a whole is only up a little over 11%. This observation holds for stocks in all regions including the US and even Emerging Markets.

So, it certainly looks like big caps are headed for a resounding victory this year, which has droves of analysts calling for a return to big cap leadership. All sorts of conventional wisdom is commonly appended to the notion that it's time for big to outperform. "Big tends to outperform small when the bull market is aging," is a familiar one.

But hold on. Just as all things must come to an end, some things seem never-ending. In fact, trends can last a lot longer than many folks believe. Even the breaking of the trend for one year in itself is not a great reason to switch to large caps just yet. With so many analysts dour on small caps today, there's a good a chance 2008 turns into the investment version of the never-ending visit from the inlaws: Where small cap leadership lingers longer than anyone would've liked.

Anything could happen next year—trends or their breakage don't tell you much about what will happen tomorrow. But if you are going to make a bet on big caps, make sure you understand what they really are—don't buy stocks that seem big but really behave small. Often the ostensibly big boys behave like small fries. But not that football captain. Unless you want to spend the entirety of the next year in your locker, you're better off letting your best gal go without a fight. Not that we're speaking from experience.