Small-Cap Smackdown: Russell 2000 Laggards Could Offer Future Opportunity

Smaller stocks have spent Q4 correcting while the rest of the market has seemingly confirmed the primary bull trend (or are we still calling this a bear-market correction?). Since month-end, the Russell 2000 has bounced back a bit from its October thrashing, but the index is down about 3% QTD while the S&P 500 has rallied over 3.5%. While smaller and larger stocks don't always move in lock-step, it is quite odd to see them move in opposite directions. As you can see in the chart below (click to enlarge), the R2000 looks a bit toppy (or is it building a base for a year-end run?):

The relationship has been fairly tame all year, with a nice run from the market low in March through September favoring smaller stocks. Since peaking in mid-September, the Russell 2000 failed once to take out that high and has now clearly lagged by giving up over 1/2 its relative advantage over the past year in a brief period. What's going on?

I believe that three factors have been influencing the recent underperformance, including the strength of the dollar, hedge-funds locking in gains potentially and tax-loss selling/window-dressing.

As far as the dollar, which has recently moved sharply back to the lows of a year ago, larger companies tend to have more of their sales and earnings coming from overseas than smaller companies. I reviewed the data over the past few years, and there is a general correlation (though the very volatile action a year ago certainly questioned the relationship).

My theory on hedge-funds is just a hunch, but one in which I have confidence. Most hedge-funds are up big this year. Their incentive fee structure encourages them to reduce risk as the marking period comes to an end. Given that they are generally long smaller stocks, where their research efforts carry more impact, it makes sense that they would be selling out smaller stocks to reduce positions.

Finally, selling pressure from tax-loss selling and window-dressing traditionally takes a higher toll on the less liquid smaller stocks (i.e. the "January effect", one of the few seasonal trades confirmed by researchers).

I last wrote about smaller stocks making more sense than larger ones just a bit early in late January. The call ended up being right, but for the wrong reason I suppose. In any event, the relationship is back to where it was then, and I believe that this could be an opportunity. Specifically, in a market that is relatively overbought, there are many smaller companies that are quite oversold due to tax-loss selling and perhaps window-dressing. The portfolio I manage has a few of these! I have been adding to some of these names in my model portfolios as well. Additionally, there are many stocks that are in a corrective phase but that look attractive.

I believe that as the calendar turns, investors will be taking a closer look at laggards as well as increasing their tolerance for illiquidity that is typically associated with smaller stocks. Smaller stocks typically have slightly higher PE ratios but are valued similarly to larger ones on a debt-adjusted basis. I guess I am looking for the January effect to work, but noting that sometimes it comes early.

Author's Disclosure: No stocks mentioned in piece

Comments

[unfaire:]

I made this comment elsewhere, but I think it is worth repeating here.
After the market crash of last year, the government rescue effort was concentrated in large cap companies. They let the small companies fall by the wayside. This is very clear from what happened to the banks. The large banks, even those which almost went belly up, got a large infusion of capital while the small banks were left to swim by its own. Before the crash, the conventional wisdom in the street was that the smaller companies have a greater possibility of leaping up their profits. But, now the conventional wisdom is that the smaller companies are more likely to fail under the present situation. No wonder, DJIA is outperforming S&P and other indices.

Nov 16 11:53 PM

[Alan Brochs...:]

I think that your comments apply well to banks, but the rescues haven't permeated much beyond the Financial sector. As to why the DJIA is doing better, I would suggest that the recovery of the bond market has certainly helped larger companies with lots of debt in terms of accessing very inexpensive (in absolute terms) money. DJIA is a funny index - the price of the stock matters. IBM, the most expensive stock per share, is also one of the best performers and has boosted the average, while C, the lowest by far, is the weakest (and has had almost no impact). In any event, DJIA is up a lot less than the S&P 500 on a YTD basis than the S&P 500.

Nov 17 07:13 AM

[mbkelly75:]

Your three factors could be right on target and I thank you for your work on this. One more thing might be going on is simple history. Small Caps tend to lead on the way out of a recession and fall back a bit as the Bull Market takes hold. This drop back may be nothing more than a normal move with Small Caps. Darned if I know, but it is also worth giving some thought to.

Nov 17 10:26 AM