Are Small Caps Vulnerable to the Fiscal Cliff?

by Daniel Putnam | August 29, 2012 12:50 pm

When investors buy into the broader small-cap asset class, they know what they’re getting: a higher-beta segment that is likely to outperform large caps on the way up and lag on the way down. Well, usually.

In the past year, though, that traditional relationship hasn’t held true. As of August 28, the iShares Russell 2000 Index Fund (NYSE:IWM[1]) had returned over 14% in the prior 12 months, lagging the 19% return of the SPDR S&P 500 ETF (NYSE:SPY[2]). But so far in August, the worm has turned and small caps have finally started to outperform: IWM has gained 3.8% versus 2.7% for SPY.

Why the shift? Previously, the ongoing concerns about Europe and China caused investors to gravitate to large, defensive, high-yielding companies. In contrast, the past few weeks have seen Europe largely drop out of the  headlines as investors turned their attention to handicapping the next round of central bank stimulus. The increase in investors’ risk appetites — as evidenced by the collapse in the VIX — has been a boon for small-cap stocks.

With the summer doldrums about to end, it’s time to consider whether this is this just a blip. Can small caps continue to outperform through the remainder of this year? While small caps’ recent run has been encouraging, the move may in fact prove to be short-lived due to an issue that still hasn’t had a major impact on financial market performance: the looming fiscal cliff[3].

Why would the fiscal cliff — the combination of tax increases and spending cuts set to go into effect at the beginning of 2013 — have a disproportionate impact on smaller companies? Unlike the European debt crisis or the concerns about China’s growth outlook, the fiscal cliff is a uniquely American problem.

And if the Congressional Budget Office’s recent revised prediction on its effect is any indication, the problem could turn out to be quite large. Small caps, by virtue of their domestic focus, may be more vulnerable to this issue than the multinationals that populate the large-cap indices. According to PNC Capital Advisors, about 80% of small caps’ sales come from North America.

It’s a matter of debate[4] whether the fiscal cliff actually will become a problem. More likely than not, U.S. policymakers will address this issue in some form before year-end. At this point, however, there’s no way investors can be sure of that. Also, if last year’s debt ceiling debate is a precedent, politicians will wait until the eleventh hour to reach a solution. At the very least, we are unlikely to see a resolution until after the election — which leaves a range of two to four months in which the uncertainty is likely to persist.

This factor may be enough to offset the wide range of natural advantages held by small caps. The asset class has not only outperformed over time, but it has been particularly strong in the fourth quarter in the recent past in a possible reflection of the “January effect” being pulled forward into earlier months.

Since the beginning of the 2000s, IWM has averaged a fourth quarter return of 5.3%, 1.8 percentage points ahead of the 3.5% average return for SPY. Small-cap stocks are also more attractively valued than large caps on a price-to-book, price-to-sales and price-to-cash flow basis, and they are in a position to benefit as cash-rich larger companies look to “buy growth” through mergers and acquisitions.

Despite this, the benefit of having a domestic focus — while a distinct positive amidst the overseas turmoil that has characterized the past three years — may become a liability as the autumn progresses. Until the concerns about the fiscal cliff finally pass, it’s reasonable to expect that investors will continue to gravitate toward large-cap, high-yielding mulitnationals — especially if the current rally loses steam in the weeks ahead.

There’s a simple way to evaluate whether this thesis is correct: Watch whether the Russell 2000 Index, which closed at 814.28 on August 28, can surpass its previous high of 847.92.

Even as the large-cap indices have achieved new high ground, the small-cap index has remained short of the same. If this current upswing concludes without the index making a new high, it’s likely that small caps’ August outperformance is likely to prove fleeting.

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

  1. IWM:
  2. SPY:
  3. looming fiscal cliff:
  4. matter of debate:

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