Summer of Small Caps: What Needs to Happen for the Rally to Continue

by Daniel Putnam | August 22, 2013 12:55 pm

Small-cap stocks have torched their large-cap counterparts so far this summer, and with good reason: Everything has been working in their favor.

In the past three months, iShares Russell 2000 ETF (IWM[1]) has gained 2.7% and beaten not just the SPDR S&P 500 ETF (SPY[2]) (-1%), but also iShares MSCI EAFE ETF (EFA[3]) (-2.9%) and iShares MSCI Emerging Markets ETF (EEM[4]) (-12.3%). In short, small caps haven’t just weathered a potentially difficult environment, they’ve excelled — and have been the only major asset class where investors have made any money.

[5]

The reasons for the strong showing of smaller companies are straightforward, but they also hold a clue as to what needs to happen for the run to continue.

Stronger Domestic Growth Makes Small Caps a Safe Haven

The first factor driving the gains for small caps is the relative strength of the U.S. economy. Although Europe[6] and Japan are both improving modestly, both economies face major structural headwinds. The emerging markets, of course, have been a basket case this year thanks to the combination of stagflation, rising interest rates and social unrest.

These issues have fed through not just to the performance of international equities, but also the various large-cap, U.S. multinational companies that are dependent on foreign sales for a large portion of their revenues. Prime examples include General Electric (GE[7]) and International Business Machines (IBM[8]): Both earn the majority of their revenues overseas, and both have lagged the broader market sharply in the past six months.

In this environment, the higher domestic exposure of smaller companies has allowed them to act as a “safe haven” at a time of relative weakness across the rest of the globe.

Rising Interest Rates a Positive for Small-Cap Stocks

The second factor supporting small caps has been the sharp spike in interest rates. Small companies have a history of outperforming during periods of rising bond yields, and they have held true to form in the past three months. Pyramus Global Advisors, in its piece “U.S. Small Caps: Outperformers During Rising Rate Environments,”[9] showed that in the period from 1979 through March 2012, small caps lagged large caps when 10-year Treasury yields were falling (with an average annual return of 11.5% to 12.09% for the S&P 500) but outperformed when rates were rising (13.94% to 13.38%).

This relationship has been even more dramatic during the past few months, as the extraordinary gains in bond yields have fueled substantial underperformance[10] for the type of dividend stocks and “bond proxies” that tend to be heavily represented in the large-cap indices.

What This Tells Us About the Rest of 2013

The importance of growth trends and interest rates provides an idea of what needs to happen for small companies to continue their run in the months ahead.

First, U.S. economic data needs to continue surprising to the upside, or at the very least demonstrate superior readings than what’s coming in from overseas. Second, a slow but steady increase in bond yields would provide a favorable backdrop for small caps, whereas a sharp decline would likely fuel renewed inflows into the higher-yielding areas of the market. A loss of one or both of these pillars will likely derail smaller companies’ streak of outperformance.

On a longer-term basis, it’s also important to keep in mind that although small-cap stocks are generally thought to outperform large caps over time, they lose their performance advantage once they are compared[11] to an equal-weighted — instead of capitalization-weighted — large-cap index.

This indicates that small-cap outperformance is a cyclical trend that ebbs and flows over time, rather than a long-term structural advantage that would indicate that mean reversion is playing any part in their recent strength.

Keep this in mind if either of the two pillars of support begins to show signs of weakening in the months ahead.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Source URL: https://investorplace.com/2013/08/summer-of-small-caps-what-needs-to-happen-for-the-rally-to-continue/

---