Unemployment and Small Cap Returns: The Nexus

Abstract

In other work (Moscarini and Postel-Vinay, 2008, 2009a), we find a distinct cyclical pattern of the relative performance of large and small businesses in terms of net job creation. Large employers destroy proportionally more jobs during and right after recessions, and create proportionally more jobs late in expansions, relative to small employers. Differential size growth between small and large firms is strongly positively correlated with the unemployment rate. This pattern is observer both in a 1978-2005 census of U.S. employers, the Business Dynamics Statistics, and among listed companies, in Compustat. In this paper, we show that this cyclical pattern of relative performance is also reflected in stock returns. Specifically, we show that the difference in returns between benchmark portfolios of small cap stocks and portfolios of large cap stocks is also positively correlated with the unemployment rate. Financial consultants and fund managers commonly recommend investing in small cap stocks during business cycle recoveries. Our findings, while consistent with that advice, pertain to all phases of the business cycle. We propose an explanation of both facts based on dynamic competition between employers of different sizes and different productivities. The model is a stochastic dynamic version of the job search and wage posting model of Kenneth Burdett and Dale T. Mortensen (1998), which we analyze in detail in Moscarini and Postel-Vinay (2009b). It is a job ladder model, where smaller firms are smaller because they are less productive, offer lower wages, therefore are less attractive to workers and less successful in poaching workers out of competing firms. This lack of competitiveness on the labor market is more of a drawback