The Smaller They Are, the Harder They Fall (Sort of)

by Dan Burrows | February 27, 2013 1:19 pm

When the market was on its way back toward record highs, we took some comfort in the fact that, at least based on market capitalization, it was behaving normally, with small- and midcaps out in front[1].

Now that the equity indices have pulled back from those peaks, though … well, the market still is acting as it should, with small- and midcaps leading on the way down, too.

Somehow that’s less comforting, even if it is perfectly natural — and less fun. As is usually the case, large-cap stocks are the place to be for defense in a falling market.

The S&P 500 peaked Feb. 19 then lost more than 2% through Feb. 26. The blue-chip Dow Jones Industrial Average — a far more concentrated index of just 30 names — held up better, sloughing off 1%. Naturally, the small- and midcaps fared the worst, with the Russell 2000 shedding 3.4% and the S&P 400 declining 3.2% as the broader market pulled back from its recent peak.

That’s just how it is: What goes up must come down.

Have a look at the chart below, courtesy of S&P Capital IQ, and see how the small- and midcaps have been market leaders over the past month — both on the way up and on the way down:


Interestingly, the riskiest stocks — the microcaps and nanocaps — have held up remarkably well. As a general rule, the smaller the cap, the bigger the gains in an up market — and the greater the fall in a down one.

But the Russell Microcap Index dropped 3% from Feb. 19 through Wednesday, a slightly smaller decline than than the benchmark small- and midcap indices. Nanocaps, meanwhile, have been generating outsized gains throughout the broader market’s ups and downs. Indeed, over the last month, they’re up 4.4%, according to data from Finviz[3], while the micro-, small-, mid- and large-cap benchmarks are all negative during that same span.

But before you get all hot and bothered, just remember that you’re not going to be plowing your nest egg into microcaps or nanos. They are, after all, hardly a sound bet or a place for anything but a smidgen of your vanity portfolio. (That is, money you can afford to lose in an attempt to beat the market; i.e., your gambling budget.)

When it comes to microcaps and nanocaps, note well that these are teeny, tiny companies. We’re talking market caps of less than $300 million in the case of micros, and sub-$50 million for the nanos. Not only do these companies have much higher probabilities of outright failure, but their shares are less liquid and more volatile. And, most important, in the case of the nanos in particular, these often are penny stocks that don’t even trade on an exchange.

Hey, if you want to gamble in the over-the-counter markets, go for it. But don’t call it investing.

If you need proof of how unpredictable these stocks can be, just look at the chart above or consider those crazy nanocap gains. What these guys are doing in a down market is outlier behavior. Proceed at your own risk.

That said, it might pay to make some tactical moves based on market cap. If we’re due for a further pullback, the S&P 500 should hold up better than the midcaps and small-caps.

If, on the other hand, you’re long and strong on equities in general, the small- and midcaps will show leadership in a rising market. As we’ve noted before, midcaps have an especially strong risk-adjusted track record through market cycles[4]. A dip is a chance to get them at even better prices.

  1. small- and midcaps out in front:
  2. [Image]:
  3. Finviz:
  4. midcaps have an especially strong risk-adjusted track record through market cycles:

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