Remember 52 Pick-Up? A dubious sibling, usually older, would ask if you wanted to play a game while holding a deck of cards. Emphatically, you agree, only to be showered with the deck of playing cards and told to pick them up. Wikipedia in its infinite wisdom defines 52 pick up as "a game of picking up thrown cards."

In a lot of ways, the market is that devious sibling. The cards are various investment strategies. Pick one up and you generally don't know which one you are going to get. Turn over enough of them, and you get better at expecting what's coming next. 

We know from an untold number of academic papers that small stocks are supposed to outperform large stocks. I'll refer to this as the "Size" effect. The simple conclusion is that small stocks outperform large stocks. 

Is this true over long periods of time? Sort of...but the actual level of outperformance is minuscule compared to other factors like Value or Momentum.

The one trend that is clear...the largest capitalization stocks--known commonly as mega cap--consistently underperform. From 1964-2015, stocks with the largest market capitalizaitions underperform by 1.7% per year. These are the stocks you hear about most often on CNBC and typically find themselves as Dow components.

Except that sometimes they don't underperform. From 2011-2015, mega cap stocks have knocked it out of the park. The larger the stock, the better it's done on average over the last five years. The Size effect has completely inverted; a fifty two year trend on its head. Anyone that oriented a portfolio in favor of the long term research ended up losing--they picked up up a 2 when they divined an Ace from that pile of thrown cards.

And so combining our knowledge of past performance with human behavior, we know that recency bias is causing investors to shun small cap stocks in favor of the factor du jour--currently low volatility. As I have written about here, here, and here, there is a pretty strong argument that low volatility has run its course in the most recent cycle.

It seems likely that most investors are underweight to small cap. The trend towards passive investing suggests that investor allocations are becoming more and more oriented towards large market cap, which suggests lower allocations to small cap.

Anecdotally, I've seen scarcely little appetite for small cap in retail and institutional investor portfolios. Ironically, any professional investor would agree that small cap is a less efficient space and a ripe place to generate alpha. Yet, so few investors take advantage of it.

To quantify my statement, below are the best and worst deciles for Value and Momentum within the large and small stock space. It's clear that the "spread",  difference between the returns for the best and worst by a factor, within small cap is much wider. In other words, historically, there exists greater potential for differentiation between the best and the worst in small stocks.

On a shorter-term basis, consider that reversion to the mean is a powerful force. Small cap stocks have done poorly over the last several years so chances are elevated that they could do well moving forward. Consider also that valuations in small cap have been improving over the last year compared to their larger siblings, orange line in the chart below. Small cap is now the cheapest its been, relative to large cap, since the credit crisis.

It just may just be the case that there are four Ace's left on the floor and one of them is small cap. Keep an eye on the space over the next few quarters. It's getting interesting.