Interest rates are shooting higher, the dollar is jumping and volatility has come back to the market with a vengeance.
Among the worrisome trends seen in stocks’ 2013 march to nominal record highs was that traditionally lagging sectors (and market caps) were leading the way up. It was kind of weird watching big dividend-payers outperform riskier, more cyclical bets like small-cap stocks.
But with bond prices falling and yields rising — the benchmark 10-year Treasury note has risen back up to 2.2% from 1.6% at the start of May — dividend stocks have lost some of their relative appeal. Additionally, the selloff in the bond market has money flowing out of debt and into equities, helping small caps along the way.
That has contributed to a semblance of normality being restored to market-cap leadership. Small caps are once again in the pole position — albeit barely — for the year-to-date. However, they are crushing the broader market and blue chips since hitting their nadir of relative underperformance in mid-April.
The small-cap benchmark Russell 2000 is up 15.6% on a price basis YTD through June 11. The broad-market benchmark S&P 500 is up 14% during the same span, while the large-cap, dividend-rich Dow Jones Industrial Average gained 15.4%. See the chart, data courtesy of S&P Capital IQ, below:
This should come as something of a relief. As we noted back when small caps were seriously lagging, the relative underperformance had some market-watchers spooked.
That’s because stumbling small caps often portend market weakness ahead. One characteristic you want to see in a rising market is small-cap leadership. Smaller companies tend to be higher-risk, higher-reward plays.
And when small caps are leading the market higher, it usually means investors are embracing riskier, more speculative bets, which in turn helps make the case for stocks in general.
The Russell 2000 turned things around right as the market was starting to get serious small-cap agita. Since April 18 — the low point of small caps’ relative underperformance — the Russell has been on a tear:
The small-cap benchmark is clobbering its cousins, adding 8.9% in less than two months. The Dow has gained 4% during the same span, while the S&P 500 added 5.5%.
Sure, the market has come so far so fast — it’s on pace for an annual gain of more than 28% — that we’re more than due for some retrenchment, backfilling and all the attendant volatility.
But at least small caps are leading once again, dividend stocks aren’t being treated as stand-ins for bonds … and risk is acting more like risk.
The market is rarely rational in the short-term, but small-cap outperformance is a more comforting norm.