- Market cap has been the most important factor in predicting returns in 2014.
- In a reversal from 2013, small and micro cap shares have sharply underperformed in 2014 and are actually down YTD.
- Investors remain extremely bullish on US equities because of strength/new highs in large cap shares, but weakness in small caps is signaling a more defensive environment ahead.
- Weakness in small caps is likely to have ramifications on investor returns not only in the near-term but for years to come.
Market Cap. There continues to be an uncanny relationship between a company's market capitalization and year-to-date returns. The largest 500 stocks in the Russell 3000 (NYSEARCA:IWV) are up an average of 8.5% this year, while the smallest 500 are down an average of -6.1%.
From the beginning of July, when the small cap Russell 2000 (NYSEARCA:IWM) Index peaked, the differential has been stark, with the top 500 stocks only marginally lower while the bottom 500 are down over -5%.
What is driving this incredibly strong relationship between market cap and return?
It can be explained in part by a simple reversion to the mean as last year the smallest stocks (microcaps) widely outpaced the S&P 500 and we are seeing a complete reversal thus far in 2014.
But there is more to the story here. As I have been writing about since January, small caps had been outpacing large caps for over fifteen years. This incredible run has left their shares extremely stretched on both an absolute and relative valuation basis.
One could quite easily make the argument that small cap valuations are at/near their most extreme in history (See: "US Small Cap Rally Sends Valuation 26% Above 1990's"). Indeed, one of the smartest minds in the investment business, Jeremy Grantham of GMO (with over $100 billion in AUM) is projecting U.S. small caps to have a negative real and absolute return over the next seven years.
This suggests that the underperformance in small caps this year may not be a short-term phenomenon and could very well continue for some time. It also suggests that small-cap effect that many have become accustomed to may be absent for a while, at least until valuations are normalized.
What does this mean for the broad markets? For now, market participants remain highly bullish and are largely ignoring the small cap weakness, focusing instead on the all-time highs in the Dow (NYSEARCA:DIA) and S&P 500 (NYSEARCA:SPY).
Many of these participants are pointing to March and April of this year when small declined in consecutive months while the large cap indices continued higher as a template for what will happen next.
While this is certainly possible, I would caution investors against assuming this is high probability and a normal market relationship. It is not. As I wrote back then, this was the first time in history that such a consistently wide divergence had occurred.
Also, if you believe that small caps are declining because of valuation concerns, wouldn't it stand to reason that investors will soon become concerned with large cap valuations? After all, while large caps are cheaper on a relative basis, they are anything but cheap on an absolute basis, as evidenced by the negative real returns expected by Grantham over the next seven years.
I would also note that despite the daily headlines about all-time highs, the most defensive area of the market, long duration Treasuries (NYSEARCA:TLT), continues to widely outperform. We are also seeing other signs of classic late cycle behavior, as I wrote about recently in showing the troubling similarities to July 2007.
Overall, the rotation out of small and micro caps should not be ignored by market participants. It is a clear sign of defensive behavior and is likely to have ramifications on investor returns not only in the near-term but for years to come.
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.