U.S. small-cap stocks are poised to outperform the S&P 500 in the first quarter of 2014 after beating the S&P 500 the past two years. Continued strength in small companies could be a good sign for the overall market because it suggests investors are comfortable taking on risk.
The epic run of the Russell 2000 Index (RTY) over the last five years has been a sight to behold. The small-cap benchmark has grown by more than 250% from the March 2009 bear-market bottom, far outpacing the Dow, the S&P 500 and the Nasdaq Composite.
As of March 12, the iShares Russell 2000 ETF (IWM) was up 2.7% year to date, compared with a gain of 1.5% for the S&P 500. The small-cap ETF posted a total return of 16.7% in 2012, and 38.8% last year.
Kimble Charting Solutions notes that the small-cap Russell 2000 is breaking through a key 15-year resistance line. It remains to be seen whether other major U.S. equity indices like the Dow, S&P 500 and Nasdaq will follow suit.
However, as The Wall Street Journal points out, market watchers are getting worried about how long this party can last. As Jonathan Krinsky, chief market technician at MKM Partners, told the WSJ:
“We are getting increasingly concerned about the extended nature of small-caps in the short-term. Forward returns for the next few months seem neutral at best, with a fairly significant risk of a 5-10% pullback.”
The Russell 2000 is trading about 42% above its 200-week moving average. That’s notable because the last time that happened was way back in March 10, 2000 — right before the stock index peaked and then tanked amid the unwinding of the dot-com bubble.
Valuations are another worry for small caps, notes investment analyst Steve Goldberg in a post for Kiplinger. Goldberg points to research by Leuthold Group, a Minneapolis-based investment research firm. Based on operating earnings over the past 12 months, the price-earnings ratio of small caps is 23% greater than the P/E of the 300 largest U.S. companies, according to Leuthold. That premium is the second-highest (after 2011) since 1983, when Leuthold began tracking the measure.
The 300 largest companies tracked by Leuthold trade at a bit less than 16 times estimated 2014 earnings. In contrast, small caps trade at an average price-earnings ratio of just under 20, according to Goldberg.
Also, small-cap stocks “tend to be riskier as they exhibit greater sensitivity to macroeconomic risks and they typically lack economic moats–or sustainable competitive advantages,” says Morningstar analyst Michael Rawson.
The greater risk in small-cap stocks is evident in their higher historical volatility relative to the S&P 500.
Still, U.S. small-cap stocks continue to plow ahead.
Rick Dworaczyk, who manages the Lower Volatility Returns portfolio on Covestor, has Vanguard Small-Cap ETF (VB) as the portfolio’s largest holding.
In late January, Dworaczyk noted in a post that small-caps are more of a play on the U.S. economy since large-cap stocks are multinational corporations that generate a higher percentage of revenue in international markets.
“I like U.S. small-caps as a core holding,” the portfolio manager said. “They tend to have higher volatility than large-caps but also tend to outperform large-caps over longer periods.”
The key question in the near-term is whether the small-cap sector is overheating and at risk of a correction. With technical indicators like the 200-week moving average flashing some warning signs, investors may need to tread cautiously in the coming months.
Photo Credit: christian.senger
DISCLAIMER: The investments discussed are held in client accounts as of February 28, 2014. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. ETF shares trade like stocks, are subject to investment risk and will fluctuate in market value. The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. Past performance is no guarantee of future results.