Should we freak out about small cap underperformance?

August 23, 2014 4:08 AM

Small Caps: The Hype

If you follow the markets, it is difficult to escape the never-ending cries about the impending gloom and doom in the S&P 500 (SPY) because small cap (IWM) stocks have been lagging large cap stocks. Below are two examples. From The Dallas Morning News:

Are small cap stocks waving a warning flag? One of the key signs of a bull market about to roll over is when just a few big stocks are pushing the indexes higher as the riskier, more volatile small caps sell off. In the two years leading up to the 2001 bear market, 80 percent of the gains in the S&P 500 came from fewer than 20 percent of the stocks. If the S&P 500 is hitting new highs, the much broader Russell 2000 should also be hitting new highs. The Russell 2000 has moved in lockstep with both the S&P 500 and the Dow Jones Industrial Average through most of the current bull market.

From CNBC:

After the worst week in two years, stocks are vulnerable to a further selloff, technicians say. From European bank stocks to small caps and junk bonds, there are a variety of indicators that are flashing warning signs, including the S&P 500 itself, which last week fell through an area around 1,950, an important support level, they said.

Small Caps: The Facts

If someone tells you to be concerned about something, it is always wise to look at history and ask:

How concerned should we be?

The chart below tells us small cap underperformance is not necessarily a show-stopper for a bull market. The top of the chart below shows the performance of the S&P 500 (large caps) relative to the Russell 2000 Index (small caps). The bottom of the chart shows the S&P 500 in isolation. When the large-cap-to-small-cap ratio rises, it tells us large caps are outperforming small caps. From 1994 to late 1999, small caps significantly underperformed large caps. During the same period the S&P 500 moved from 443 to 1,419. Said another way, during a period of small cap underperformance, the S&P 500 increased by a factor of 3.2, which is a massive gain in the broader stock market.

We have covered this topic in the past; thus if you want more evidence, Busting Small Cap/Stock Market Risk Myths is a good source.

Investment Implications – The Weight Of The Evidence

All things being equal we would prefer to see small caps outperform their more established and larger brothers. However, having small caps lag, taken in isolation, is not a reason to sprint for the nearest equity exit. Rather than focus on small caps alone, it is best to look at all the evidence from multiple markets, asset classes, and ratios, something we accomplish via our market model. The weight of the evidence was somewhat shaky as of the close on Friday, August 15. Somewhat shaky does not mean bearish; it means it was prudent to reduce equity exposure until the market provided us with a bit more clarity from a probability perspective. The odds began to improve on Monday, August 18, prompting us to increase our equity exposure to get back aligned with the hard evidence.

Fed Remains A Concern

When this article was penned, the market was still digesting Janet Yellen’s Jackson Hole address. There is no way to sugar coat the impact of rate hikes from central banks. All things being equal, markets prefer to see rate cuts rather than rate hikes. However, the market and evidence will begin to show some observable signs of deterioration if interest rate concerns begin to threaten the rally in equities. Therefore, our approach does not change. We will continue to monitor the evidence with a flexible, unbiased, and open mind.

Freak out image from Karl-Ludwig Poggemann via Flickr creative commons.

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