MorningWord 10/01/14: A Tip of the Cap? – $IWM, $SPY

by Enis October 1, 2014 9:33 am • Commentary

Small cap stocks continue to get bludgeoned while investors seek the safety of the large caps.  The S&P 500 index is up 7% year-to-date, while the Russell 2000 index is now down more than 5% year-to-date.  After yesterday’s decline in the Russell 2000, the IWM is now back in the crucial $107-$110 support area that has not been breached in 2014:

IWM daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg
IWM daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg

The outperformance of large cap stocks over small cap stocks in the past 6 months has taken the IWM/SPY ratio down to a 3 year low:

IWM / SPY ratio, courtesy of Bloomberg
IWM / SPY ratio, courtesy of Bloomberg

However, if we zoom out to a 15 year time frame, the recent underperformance is still a small blip compared to the long-term trend of small caps outperforming large caps in that period:

IWM / SPY ratio, courtesy of Bloomberg
IWM / SPY ratio, courtesy of Bloomberg

The real question is whether the small cap reversal since March is the start of a long-term trend of small cap underperformance.  If that’s the case, then the relative underperformance of small cap stocks has a long way to go.

I touched on the fundamental overvaluation of small caps vs. large caps in a March CotD post on IWM:

Another indication that many of the small cap stocks are in bubble territory is that the median measures of valuation are near all-time highs, even as the mean measures of valuation don’t look so frothy (once again, the mega caps are not too expensive, but many stocks in the market are very expensive vs. history).  Here’s a chart from Goldman research illustrating that:

Screen Shot 2014-03-10 at 1.19.26 PM

The broader optimism in the market has led to the usual symptoms of a bubbly market – major M&A on dubious grounds (FB buying WhatsApp), large IPO issuance, and huge moves in little known sectors (marijuana, fuel cells, and small cap biotech for example).

Large caps vastly outperformed into the end of the 2000 tech bubble top, but were priced much more richly relative to small caps as a result.  The reverse was true 6 months ago, which makes me think that we are at the start of a longer-term trend.

This caution regarding small cap valuations is not new.  Michael Santoli of Yahoo Finance wrote an article last November discussing the concern about small cap fundamentals:

Small caps are now exaggerated versions of the overall market  enjoying a powerful uptrend, reflecting a prosperous corporate sector and supported by generous monetary stimulus, but valued in such a way that multi-year forward returns are likely to be unimpressive. Many long-tenured market watchers are suggesting that either now or over the next several months, big-company stocks will likely become the better way to play any additional upside in this bull market  especially as the market begins anticipating a likely step-down in the Fed’s asset buying.

The Leuthold Group, which has tracked stock-market mechanics and fundamentals since 1981, has lately characterized what we’re witnessing as perhaps “a final gasp in small-cap leadership.”

The firm calculates that, based on a variety of measures tied to underlying company profits and balance sheets, small stocks trade at roughly a 40% premium to the S&P 500 – essentially as pricey as they’ve been in the “modern era.” The firm grants that valuation alone isn’t a great clue to how stocks will do in the short- or medium-term. But at this elevation, and given that small caps are more prone to “fall of their own weight” absent a recession than big stocks, the risk-reward looks poor here.

Since then, the Russell 2000 is essentially flat, while the S&P 500 index is up about 10%.

If history holds true to form, avoiding small caps in favor of large caps (on a macro basis) will probably be a profitable strategy for many years to come.  That might also signal a shift from growth strategies (often more small to mid-cap biased) towards value strategies (more large-cap biased).  These shifts can take years to play out, but the overall market landscape looks to be undergoing quite a seismic shift.