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Is It Too Late to Buy the Rally in Small Caps?

The key tailwinds remain in place, but don't get carried away

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Domestic small-cap stocks have been annihilating all other asset classes since the beginning of the year, building on their gain of nearly 39% in 2013.

SmallCaps185The iShares Russell 2000 ETF (IWM) has rallied nearly 4% year-to-date, better than large caps, international stocks, bonds, and just about every other significant market segment with the exception of gold.

The question now is whether this rally has gone too far, or whether small caps still have room to run.

Fortress America

The case for small-cap stocks is easy to make right now. Since the start of the year, the largest issues that have unnerved investors have originated from overseas: instability in emerging market currencies, worries about credit conditions in China, and more recently the conflict in Ukraine.

These headwinds have led to underperformance not just for U.S. large caps, which have a larger percentage of overseas revenurs than their small-cap stocks counterparts, but also the international markets. Europe has barely eked out a gain, while Japan and the emerging markets have both posted losses in the mid-single digits.

In the United States, meanwhile, it’s business as usual — and small caps continue to be the best play on the relative stability here at home. Small-cap stocks are the asset class that is most isolated from the trouble overseas, and also the best way to play the improving growth outlook for the United States. For investors looking to put incremental cash to work in stocks, the choice has been an easy one.

From a longer-term standpoint, another important tailwind for small-caps has been supply and demand. According to a T. Rowe Price (TROW) report titled “Shrinking U.S. Equity Opportunity Set Poses Challenges for Small-Cap Investors,” a tougher regulatory environment is preventing small companies from coming to the market via IPOs. As a result, the pipeline of new companies isn’t coming close to replacing those that have moved out of the small cap indices.

The report states: “The erosion of the small-cap opportunity set can be seen in the composition of the Wilshire 5000 Index, which declined from more than 7,000 stocks in 1999 to just 3,776 at the end of 2013.” With so much cash looking for a home in the era of low rates, this shrinking demand has been a boon for small caps, and it should continue to provide support in the coming years.

Together, these factors indicates that small caps can continue to outperform in the short term, barring an unforeseen drop-off in economic data in the weeks and months ahead. Or, put another way: ride the wave as long as you can.

Why Small Caps May Lose Their Gusto

For investors with a longer-term horizon, the outlook is a little dicier. Since the March 9, 2009 low, IWM has gained 275%, for an average annual return of 30.3%. One result is that valuations have rocketed to levels that are extremely high on a historical basis.

Article printed from InvestorPlace Media,

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