- The recent behavior of small caps is hard to explain.
- In particular, many traditional size-timing indicators no longer work.
- One explanation could be a sector specific shock: technology.
- I would thus reconsider being long small stocks soon.
Small stocks usually behave in accordance with a few markets or indicators:
i. They have a positive return and/or outperform big stocks when the economic news flow improves. Yet, over the recent past, the improvement in the economic momentum failed to bolster small stocks.
ii. Small stocks and high yield bonds also have the same pattern of returns. If the link would have understandably temporarily disappeared during last year's tapering fear, there has been no genuine recoupling since.
iii. Moreover, the relationship (either in relative returns against big stocks or in absolute returns) with U.S. treasury yield has also weakened significantly since late 2013 (below I use the TLO ETF).
iv. Lastly, even the rebound in the S&P 500 failed to drive small caps to the upside.
Since the work of Fama and French in 1992, and in particular the introduction of their size factor SMB (small minus big), small stocks were deemed to provide a higher return than larger stocks. But this relationship is far from obvious. If you take the 1980-2000 sample, there is no evidence of any significant outperformance of small stocks. Since 1999, however, small caps have clearly outperformed the S&P 500. So, if there is any outperformance, it is clearly erratic.
Yet, as I have shown above, there are a few macro drivers (U.S. Treasury yields, news flow), that should help what is generally called size-timing. It seems,yet, that even those factors are currently inefficient.
So what has been driving small caps recently? Of course, Janet Yellen seeing "pockets of possible over-valuation in small caps" has not helped. Moreover, as many small caps draw their outperformance from takeover activity, the subdued level of M&A in comparison to the pre-Great-Recession period could explain the relative weakness of the small cap index, yet the lackluster activity in M&A is not new.
Therefore, my best explanation for the recent behavior of small caps is more micro than macro. A glimpse at the co-movement of NASDAQ and the small cap index suggests that it could be related to a specific sector, namely technology.
Bottom Line: The disconnect between several macro/market factors and the size-timing of the equity market may be explained by the recent comments of Yellen. The best explanation comes from a more micro/sector specific factor: technology. Therefore, it might be a good time to buy small stocks again.