Assessing the dynamic relationship between small and large cap stock prices

Abstract

The historical long-run return on small capitalization stocks has unquestionably outperformed large capitalization stocks since 1926. The phenomenon of small capitalization stocks having higher risk- adjusted returns compared with large capitalization stocks is an equity market anomaly first discovered in 1981. Since then, many academics and investors have strongly argued that is dead. This paper argues that far from being dead, the phenomenon of size effect appears alive and well and it could be exploited effectively over long-term investment horizons. To analyze this phenomenon, we focus specifically on the dynamics of small cap and large cap prices. We test for multivariate cointegration among the small cap and large cap stock prices and other major macroeconomic factors from 1980 to 2006. After conducting robustness tests on forward recursive and ten year rolling samples, we find evidence of one long- run cointegrating vector. Of more importance, there is a consistently negative and highly significant relationship between small and large cap stock prices. This could suggest that the size effect exhibits a cyclical pattern. Our analysis also provides supporting evidence that the size effect appears to exhibit predictable reversals when considering long investment horizons. Furthermore, we demonstrate how small cap stocks can be viewed as less risky than large cap stocks over long holding periods. Finally, we make suggestions on how asset managers and individual investors can enhance returns based on our overall results.