A Simple, Aggressive Approach to Large-Cap versus Small-Cap

  • SumoMe

Certain “arguments” just seem to last.  Since I started in this business (As best as I can recall, stock prices were reported on an abacus at the time) there has always been someone willing to pursue the “large cap versus small cap” and/or “growth stocks versus value stocks” argument.  Early in my career “everyone knew” that “in the long run” (usually defined – incorrectly – as the most recent 2-5 years) small cap stocks “outperform” large cap stocks.

Is this actually true?  The answer is “Yes, but only sometimes.”  The same answer holds true or growth versus value.  In short, no matter what you hear (at least in my humble opinion) there is no compelling evidence that large-cap stocks inherently perform better or worse than small-cap stocks nor that growth stocks perform better or worse than value stocks.  That’s the bad news.

The good news is that the interplay between large-cap and small-cap (and growth versus value) fluctuates – or more accurately, trends – over time.  In other words, it is not uncommon for large-cap stocks to outperform for awhile and then for small-cap stocks to outperform for a good long while.  If one can identify a trend then an opportunity exists.

One Simple, Albeit Aggressive Way to Play

The method I am about to describe is really pretty simple, however, it does involve risk as the method uses a leveraged mutual fund.  As a preface, the “safe” news is that this method is in the market only about 44% of the time (and is safely tucked away in cash the other 56% of the time). The “dangerous” news is that when it is in the market it is in a leveraged mutual fund that tracks large-cap stocks.  So, bottom line: it is not necessarily for the faint of heart.  More to the point though, it may be ultimately be useful to traders who are willing to invest a certain percentage of their capital in more “volatile” investments in hopes of an above average longer-term return.

So here are the steps:

A = Closing price for ticker RUI (Russell large-cap)

B = Closing price for ticker RUT (Russell small-cap)

C = 252-day % Rate of change for ticker RUI ((A / A 252 trading days ago)-1)*100

D = 252-day % Rate of change for ticker RUT ((B / B 252 trading days ago)-1)*100

E = (C – D)

If E > 0 this indicates that large-cap stocks have outperformed over the previous 252 days, and vice versa.

Trading Rules

If E > 0 today then buy ticker ULPIX (Profunds UltraBull) tomorrow and hold until E < 0.

If E < 0 today then sell ticker ULPIX and hold cash until E > 0

OK, not exactly “sophisticated”, still as a proud graduate of “The School of Whatever Works” (all hail good old “SWW”), I am far less interested in “process” as I am “results”. Which leads us directly to:

The Results

The test I ran started on 10/15/2001 when ticker ULPIX first began to trade.  The equity curves for the method described above versus buying and holding ticker RUI appear in Figure 1. jotm2014-0724-01Figure 1 – Growth of $1,000 using Jay’s ULPIX Method (blue line) versus buying and holding ticker RUI (red line); 10/15/01 through 7/23/14.

In a nutshell, $1,000 invested using the system grew to $4,257 versus $1,932 using a buy-and-hold approach.  The year-by-year results appear in Figure 2.

Year

System

RUI

2002

1.0

(22.9)

2003

26.6

27.5

2004

2.0

9.5

2005

(9.3)

4.4

2006

23.7

13.3

2007

8.0

3.9

2008

10.3

(39.0)

2009

49.7

25.5

2010

8.9

13.9

2011

6.8

(0.5)

2012

15.1

13.8

2013

8.0

30.6

2014

12.5

7.4

Average

13.0

4.5

Std Dev

15.8

19.8

A/SD

0.821

0.226

Figure 2 – Annual Results; Jay’s ULPIX System versus Buy-and-Hold

As you can see in Figure 2, since 2002 the system has averaged 13% annually versus just +4.5% for buy and hold.  It should also be noted that the standard deviation of annual returns was lower for the system.

On the downside investors should be sure to note that despite the fact that the “system” showed a gain for 2008, it nevertheless experienced a -42% drawdown during 2008. So just, repeating now, this method cannot be characterized as “low risk” in any way shape or form.

It is also worth noting that the annual system results versus buy and hold is all over the place.  So anyone looking for an endless string of “out performance” year after year, will definitely need to look elsewhere.  The proper perspective is this: when the system is in the market it occasionally makes a lot of money.  When it is out of the market it doesn’t make much at all – even if the stock market overall is rising.

For the record the system has been in ULPIX since the close on 5/7/14 and shows no immediate signs of getting out.  As of 7/23/14, RUI is up 17.8% and RUT is up 10.1% over the latest 252 days.  So “Value E” from above is +7.7%.  The system will continue to hold ULPIX (for better or worse) until Value E once again falls into negative territory.

Summary

As always, I am not recommending that anyone rush out today and jump into large-cap stocks just because the method I have described is presently bullish.  Nor am I even suggesting that anyone should adopt this system.  Before anyone engages in any type of trading that involves the use of a leveraged mutual fund, there are a few introspective questions to be asked and answered regarding one’s own tolerance for risk, what type of asset allocation is reasonable, and whether The School of Whatever Works offer classes online? (OK, just kidding about the last one).

The real point of this piece is twofold:

1) To dismiss the notion that large cap stocks are inherently a better investment than small-cap stock, or vice versa and;

2) To illustrate that with a little bit of analysis and effort it may be possible to come up with simple methods that take advantage of trends in the marketplace.

Now if you’ll excuse me, I have to get back to class.

Jay Kaeppel

 

2 thoughts on “A Simple, Aggressive Approach to Large-Cap versus Small-Cap

  1. Jay: What am I missing, the system above using UWM does even better than ULPIX. TNA is better yet. I thought you were supposed to be out of small stocks during buys. I checked my calculations a couple of times. I do not understand.

    1. Satish, thanks for the comments and questions. A couple o’ things to note. First off, this particular “system” is presented “as is”, which only means that there is no intention to imply that it cannot be improved upon. Also, the implication of the system is that the market (overall) tends to perform better when large-cap is leading small-cap (although I know people who would argue the opposite – I am just using the numbers that turned up when I started running this test way back when). I used ULPIX only because it tracked more closely with RUI and large caps tend to be slightly less volatile than small caps. But in the end, any stock index fund or ETF can replace ULPIX in this system. Bottom line, if a person was to trade using this and was comfortable trading UWM or TNA (although that is 3x so entails another degree of risk and volatility), then there is nothing wrong with that. At the same time, a trader seeking less volatility could choose a less volatile index fund or ETF (for example, SPLV). Results would be reduced but so would volatility along the way. Hope that helps. Jay.

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