The US economy has been in an expansionary phase since it last bottomed out back in June 2009. We have no idea when the current expansion might peak and turndown, but just as clouds and rain are inevitable, so too is a future recession. Although not perfect, the broad US equity market is a well-known indicator of recessions—tending to turn negative just before the economy peaks and heads down. But if we turn the focus to small cap behavior via the small cap premium, a completely different pattern emerges.
The small cap premium represents the return differential between a small cap stock and a large cap stock. It is designated as a premium due to the historical tendency for small caps to outperform large caps in the long run—although that is not always the case in the short term.
To conduct this analysis, we used the last five complete expansionary cycles of the US economy as defined and dated by the National Bureau of Economic Research (NBER), seen in the table below. We are currently in the sixth expansionary period for which the peak has yet to be announced.
To assess the performance of the broad market we use the Russell 3000® Index, and for the small cap premium we use the return differential between the Russell 2000® Index and the Russell 1000® Index. For each of the five completed business cycles shown above, we computed the 12-month forward looking return at nine different points in time—three, six, nine and 12 months before and after an NBER-defined peak as well as at the peak itself. We then took the average return from each business cycle at those points in time and created the bar chart below.
As we can see, the average 12-month forward looking return for the broad US market turned negative nine months before the recession began and stayed close to zero or negative through the beginning of the recession. By contrast, while the 12-month small cap premium also turned negative nine months prior to the recession, it flipped to positive at three months prior and stayed positive throughout the recession.
As anyone who has found themselves soaking wet in an unexpected rainstorm knows, historical statistics are not always reliable predictors. But a look back at history can provide some clues as to how equity markets might behave in and around a recession. While broad market performance as a leading indicator of recessions is nothing new, the behavior of the small cap premium just prior to and during the recession might be surprising. Market participants may find this information useful when navigating future business cycles.
For further detail on how we conducted this analysis, refer to The US Small Cap Premium and the Business Cycle paper.
 As determined by the National Bureau of Economic Research (NBER) as of September 30, 2016. The NBER is a private non-profit US-based research organization. It has no official status, but many US government agencies and economists rely upon NBER dates in its research.
© 2016 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, “FTSE TMX”) and (4) MTSNext Limited (“MTSNext”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE TMX and MTS Next Limited. “FTSE®”, “Russell®”, “FTSE Russell®” “MTS®”, “FTSE TMX®”, “FTSE4Good®” and “ICB®” and all other trademarks and service marks used herein (whether registered or unregistered) are trade marks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, or FTSE TMX.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for any errors or for any loss from use of this publication or any of the information or data contained herein.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group index data and the use of their data to create financial products require a license from FTSE, Russell, FTSE TMX, MTSNext and/or their respective licensors.