One pattern of stock market behaviour is predictable: small-cap stocks are the biggest gainers in bull markets and the greatest losers in bear trends.

Investment researchers in the U.S. long ago discovered this real “small-cap effect” in the market. Thus the strength of small-cap stock indices since the market low in February 2009 is good news for your clients’ equities portfolios, as it confirms the fact of a bull market, whose existence has appeared to be precarious throughout the summer.

However, the pattern has varied in the current rally, which began when the crash reached the bottom in February 2009. In the U.S., mid-cap stocks are gaining marginally better than small-caps.

The performance figures look like this:

> The S&P/TSX small-cap index is up by 89% since the February 2009 close. In contrast, the S&P/TSX completion index (mid-cap stocks) is up by 76% and the TSX 60 index (large-caps) is up by 46% in the same period.

> On Wall Street, the S&P small-cap 600 index is up by 74% since February 2009, vs a larger 78% gain for the 400-stock mid-cap index, and a 55% rise by the S&P 500 (large-caps) index.

The Russell mid-cap index has gained 82% vs a 74% rise by the small-cap Russell 2000 index and a 58% gain by the large-cap Russell 1000 index. The comparison is blurred because the Russell mid-cap index consists of the smallest stocks in the large-cap Russell 1000 index and the largest stocks of the small-cap Russell 2000 index.

For the truth of the corollary — small-cap stocks lose most heavily in bear markets — the changes between the Canadian market’s 2007 high and its February 2009 lows are clear. The S&P/TSX small-cap index lost 56%, the mid-caps lost 51% and the TSX 60 index lost 42%.

Indeed, when you filter income trusts out of the small-cap index, the loss by equities small-caps was a greater 62%.

The stock market collapse from the highs of 2007-08 to the February 2009 low preceded a drop in corporate earnings. This emphasized, once again, the stock market’s predictive powers.

For instance, the TSX 60 index’s monthly closing high was reached in May 2008 but its earnings peaked in the following December.

Small-cap stocks peaked in May 2007, while their earnings topped out in December 2008. As is typical, earnings of the small-cap index turned into a loss that lasted 16 months.

Despite the vigorous rise in earnings for all market-capitalization sectors, the sluggish response of dividend payments reveals corporate caution. In the S&P/TSX small-cap index, the index-adjusted dividend has hovered around $17.50 for the past year.

Similarly, the dividend on the completion (mid-cap) index has ranged between $22 and $24 in the same period.

The TSX 60 index’s dividend has risen slowly to $18.60 recently from $17.50 a year ago. That payment was almost $22 two years ago.

Those few investors who risked buying stocks in early 2009 — when Canadian and U.S. equities indices had halved in just a few months — did not always fare well in the small-cap sector.

The accompanying table shows how the largest-weighted and smallest-weighted stocks in the TSX small-cap and completion indices in February 2009 have fared subsequently. Small-caps, again, have revealed their vulnerability. Four of the 10 lowest-weighted small-caps have since been delisted, with only one rising in price before being delisted.

But some of the gains among the lowest-weighted small-caps from the depths of the crash have been enormous — a pattern echoed by the lowest-weighted mid-cap stocks. Once again, the lesson of “high risk, high reward” has proven to be true.

Fundamental valuations of these companies have generally increased, as indicated by price/book value ratios, although to risky-looking levels for a few — notably Garda World Security Corp., Keyera Facilities Income Fund, IGM Financial Inc. and Calfrac Well Services Ltd.

Baffinland Iron Mines Corp.’s price/book ratio of 1.5, meanwhile, reflects a pending takeover offer. IE