While the S&P 500 index of large of U.S. companies managed to eke out a 1.1% gain for the quarter ending on September 30, 2014, most major indices incurred losses. In particular, the Russell 2000 index of small companies suffered a 7.4% decline.
That sharp sell-off in small cap stocks could spell trouble for the broader market. The bull market that began in March of 2009 is looking vulnerable to a correction.
Small Cap Woes
In the past, periods of significant underperformance for the Russell 2000 versus the S&P 500 were strong indicators of future problems for the overall equity market.
In the last quarter, the Russell 2000 underperformed the S&P 500 by 8.5% representing the largest quarterly underperformance since March 31, 1999.
In that year, markets continued to rise for the remainder of the year, only to fall the next three years in a row. The S&P 500 suffered losses of 9.0%, 11.9%, and 22.0% in the years 2000, 2001, and 2002, respectively.
This past quarter was the fourth consecutive quarter in which returns for the Russell 2000 were less than those of the S&P 500. This trend last occurred in the quarter ending March 31, 2008. Over the next twelve months the S&P 500 lost 38.1%.
It is hard to pinpoint a fundamental reason for large companies (S&P 500) outperforming small companies (Russell 2000) in the latter stages of a bull market.
In my opinion, it might reflect investors’ collective attempt to reduce risk in an expensive market by shifting assets to larger companies, which are perceived to be safer, more stable investments than smaller companies.
Welcome Downturn
The previous two bull markets ended following periods of significant underperformance for the Russell 2000 index.
Considering the recent weakness of small company stocks as compared to large company stocks, some caution seems to be warranted.
Indeed, a correction in the S&P 500 Index would not be totally unexpected, and might even be considered beneficial, since stocks would become more reasonably valued.
In addition to large companies performing well, it has been a banner year for IPOs (initial public offerings). In September, Alibaba (BABA) became the largest IPO ever by selling $25 billion of shares to the public. So far, 2014 is the second best year ever for IPOs of companies listed on U.S. stock exchanges.
With three months left in the year, there is a good chance that 2014 IPOs will surpass the previous record year of 2000. Unfortunately, record levels of IPO activity have also been a decent indicator of a market top.
As noted previously, markets experienced a three-year downturn beginning in 2000. Hot IPO markets often reflect speculation by investors. In the case of Alibaba, shares rose 38% on the first day of trading, raising concerns that investors were chasing returns without regard for risk.
Fed Tightening
The Federal Reserve’s bond buying program is expected to end in October, which will likely lead to higher interest rates. This program, known as quantitative easing, has helped to keep interest rates near 0% in an effort to stimulate the economy.
While the Fed intends to keep interest rates low using other tools, most observers expect a gradual increase in rates, assuming economic growth remains healthy.
A rising interest rate environment is generally negative for stock investors, since it results in higher borrowing costs for businesses and consumers.
Higher interest rates make new fixed income investments more attractive compared to stocks, but cause the price of existing fixed income investments to fall.
Finally, it is worth mentioning several other issues which could continue to weigh on market sentiment, including the ongoing Russian-Ukraine tensions, the Islamic State conflict, the Ebola virus, recession fears in Europe, and slowing growth in China.
Of course, not all the news is bad. There are plenty of reasons to continue holding stocks.
Earnings outlook
Earnings for companies comprising the S&P 500 index are at record levels and are forecasted to increase by 7.5% for 2014.
The U.S. economy continues to expand at a healthy pace, with the IMF (International Monetary Fund) projecting growth of 2.8% for 2014 and 3.0% for 2015.
Unemployment has declined to 5.9% from a recession peak of 10.0% in 2009.
The shale gas boom has kept energy prices low and reduced the need for imported energy. Interest rates remain at historically low levels, and inflation is running below 2% for the third year in a row.
The U.S. budget deficit for 2014 is forecast to decline to its lowest level since 2008.
Bond markets were relatively flat during for the quarter. The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, generated returns of 0.2% for the third quarter.
The yield on the 10-year Treasury bond ended the quarter at 2.51%, virtually unchanged from 2.52% at the end of June.
Longer-term fixed income investments still appear to be unattractive considering that interest rates will likely increase as the Fed unwinds it quantitative easing program.
Taking all of these factors into consideration, we continue to believe equities will outperform other asset classes over the long term.
Since short-term market moves are largely unpredictable, it is important that investors maintain an asset mix that is appropriate for their objectives and risk tolerance, utilize diversification to control risk, and own investments that are reasonably valued.
These fundamental principles continue to guide our portfolio management process. We feel strongly that the securities currently held in our client portfolios are well positioned to produce attractive returns over the long term.
DISCLAIMER: 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.
