Should Changing Market Dynamics Concern Small-Cap ETF Owners?

by: Gary Gordon

For the better part of six months, small company stocks have outperformed large company stocks. That's not unusual for an unapologetic bull rally. Indeed, if investors are embracing risk, then they are typically willing to pay a higher price to own faster growing corporations.

Since the beginning of October, however, riskier holdings have been losing momentum to the large-cap bellwethers. The iShares Russell 2000 (NYSEARCA:IWM):SPDR S&P 500 Trust (NYSEARCA:SPY) price ratio demonstrates the relative weakness in smaller company stock shares.

Granted, the major news outlets tend to focus on the Dow, the Nasdaq, and the S&P 500. Moreover, many programs enjoy enhanced ratings by covering sexy topics like the Twitter (NYSE:TWTR) IPO. Still, it may be a disservice to viewers when talking heads celebrate factoids like, "the market has been up for 17 of the last 20 trading days." Expressing enthusiasm for the Dow in this manner may ignore other facts, like the IWM trading at the same price that it did at the start of October.

Is it possible that investors are beginning to grow squeamish about small company valuation? Are trailing P/Es of 85 and forward 12-month P/Es of 25 a little too rich for some people's blood? Hard to say. Yet a continuation of Federal Reserve interest rate manipulation alone does not seem to be reason enough to overweight IWM.

Interestingly enough, the valuation concern is not present in Europe, Australia (Australasia) and the Far East. Consequently, small-cap outperformance has not waned; the iShares MSCI EAFE Small Cap (NYSEARCA:SCZ):iShares MSCI EAFE (NYSEARCA:EFA) price ratio shows that SCZ is maintaining its relative strength.

The under-achievement of small caps is not the only sign that investors may be turning defensive. The First Trust Equal Weighted NASDAO 100 (NASDAQ:QQEW) has been giving ground to the SPDR Dow Jones Industrials Fund (NYSEARCA:DIA). Ostensibly, investors appear to be backing away from tech-heavy growers and favoring "old school" favorites in the Dow Industrials. The QQEW:DIA price ratio looks ominously similar to the IWM:SPY price ratio.

While few people believe that the Federal Reserve would enact a surprise tapering in December, some folks may be charting a more defensive course in light of an eventual tapering in 2014. Of course, a lot may come down to the October jobs report (to be released on Friday, Nov. 8) as well as the November jobs report, set to be released in early December. Job growth and wage growth will be the Fed's main justification for backing away from buying U.S. debt at the same pace. Weak jobs reports would likely keep the Fed on hold much longer, and the markets rising with all the complacency that 2013 has represented.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.