Nobody feels the pain on Wall Street these days quite like the little guy.
A fairly common indicator of how “healthy” the stock market is involves the performance of smaller companies vs. their blue-chip brethren. And if you’re watching that metric right now, it’s clear that the stock market is hacking and wheezing.
Click to Enlarge Just check out the underperformance of the benchmark Russell 2000 index vs. the Dow Jones Industrial and S&P 500 as the market cooled and the financial crisis came home to roost.
Though blue chips peaked in 2007, the underperformance of the small-cap index before that was a warning sign — and the meltdown in 2008 shows smaller stocks taking a more severe beating then larger corporations.
Click to Enlarge Fast forward to present day: Small-caps peaked in May 2011 after a rebound rally from 2009 lows and are back to their sickly ways of underperformance. The Russell 2000 is barely flat as of this writing compared with 5% gains in the S&P 500 and Dow Jones across the past 13 months or so.
It looks like an ugly situation for small caps. And from what some are saying, it’s about to get worse before it gets better.
Bigger Might Not Be Better, But It’s Safer
The flight out of small caps is logical when you consider the Wall Street landscape. Here are the three big reasons folks are looking away from the little guys:
Risk: Investors are avoiding risk like the plague. When a meager 1.5% yield on 10-year T-Notes is “good enough” for many portfolios — and others trust Treasuries so little they are in cash — that tells you everything you need to know. The inherent risk in a smaller stock without scale or a safety net has scared off many investors, even from good small-cap companies.
Stability: Blue chips can get pummeled too, as the meltdown of 2008 showed us. But a certain class of large-cap stocks are undoubtedly stable — staples stocks like Kraft (NYSE:KFT) have strong baseline demand, public utilities like Duke Energy (NYSE:DUK) are legalized monopolies and telecoms like AT&T (NYSE:T) aren’t going anywhere thanks to the ubiquity of smartphones and the Internet. Why chase an up-and-comer in a challenging economic environment when you can have an entrenched giant that will weather the storm?
Yield: Throw in the fact that Kraft yields 3% — twice the 10-year Treasury bond — while utilities are north of 4% and telecoms are north of 5% and you can understand the attraction. Small-caps in growth mode, however, are plowing their cash into their business instead of dividend payments.
So are big stocks “better?” Hardly. There are a number of small-caps that have outperformed nicely in the last few months — and some of these picks will have bright futures. But the fact remains that many small-caps will suffer more severely in the short-term amid market volatility and macroeconomic challenges.
Even the Good Get Punished
One final word of warning in case you believe the platitudes about a “stock picker’s market.” Yes, some small caps are great for swing traders if you get in at the right time and get out for a quick gain. And yes, some stocks under $2 billion indeed have staying power and continue to march upward thanks to superior products and strong growth potential.
However, I caution you that the market is challenging and unforgiving for stock pickers. So tread lightly if you’re dabbling in small caps right now.
Take my old boss, Louis Navellier, who is one of the best fundamental analysts in the business. I used to work as an editor for his economic and stock commentary and got to know his proprietary methodology for separating the winners from the losers based on sales and profit trends.
Click to Enlarge But according to Navellier, right now methodology doesn’t matter worth a darn. That’s because only an elite group of small caps are posting gains — and tiny gains at that — while the vast majority are gutting shareholder portfolios. Take a look at this chart to see what happens when the market is carved up into 20 slices, with the most fundamentally sound balance sheets at the top and the ones bleeding red ink at the bottom.
The latter 50%, as no surprise, is posting deep losses. But the top 50% is barely even treading water. In fact, many of the “best” small caps still are losing money for shareholders.
Louis still is dabbling in small caps, trying to focus on that blue bar to the far left. But in his words, “only the top 5% of small- to mid-caps are OK to buy.”
That’s not much margin for error.
Of course, it’s worth noting that small caps likely will benefit most when a raging bull market returns. All that cash on the sidelines will want to chase the best opportunities in fast-growing corporations.
However, we are a long ways away from a raging bull market — and we seem a long ways away from a macroeconomic picture that favors smaller upstart businesses. Consumers and businesses remain conservative in their spending, access to capital markets isn’t easy for new enterprises and many think the mayhem in Europe is going to drag on the global economy for some time.
My advice: Steer clear of small caps for now.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff Reeves did not hold a position in any of the aforementioned securities.