The Present Market Behavior Reminds Me Of The Past

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Includes: DIA, IWM, QQQ, SPY
by: Paulo Santos

Summary

There's something in this market which reminds me of the dotcom bubble.

No, it's not valuations or bubbles. It's something different.

In time, this should mean small-caps ought to outperform large capitalizations, or at the very least, any drop in small-caps will be matched by large capitalizations.

There is an eerie "Dejá Vu" in the market. This has to do with how small caps are underperforming the large cap indexes so strongly as of late. This trend can be seen in the $SPX:$RUT (S&P500/Russell 2000) ratio since about March 2014 (Source: Stockcharts.com)

This reminds me of the market back during the dotcom bubble. Then, too, a similar effect took place. Small-caps started underperforming at the tail end of 1997, and then the underperformance lasted until late 1999, when it suddenly reversed due to the dotcom bubble starting to push tech small caps to extraordinary levels, which took the Russell 2000 (NYSEARCA:IWM) with it.

The main driver of this underperformance back then was, in my view, the relentless nature of the market's upward trend. At some point, manager after manager quit trying to manage. They just indexed or closet-indexed their funds.

I saw this dynamic personally in the way the pressure rose for us to do the same at the fund shop I worked at the time. They called it "the performance engine". That is, you indexed and used very low cash levels to keep up with the market, the market would do the rest regarding performance since it always rose.

The same thing seems to be happening now - faced with a relentless market, passive investing, indexing and closet indexing are again showing renewed strength. People just want to be in the market, and for their cash levels to be low. While it's hard to prove that indexing is growing in strength (though ETFs have seen an extraordinary explosion in assets that's rather obvious), the cash levels present a very similar story to what happened back in 2000 (Source: Zerohedge.com)

Why does indexing then produce the small-cap underperformance?

If this is indeed happening again, then it begs the question: Why does indexing produce this small-cap underperformance?

The answer is relatively simple. When funds go from a more active stance to indexing or closet indexing, they go from considering all or most of the market investable, to mostly tracking a well-known benchmark such as the S&P500 (NYSEARCA:SPY). Seldom do they fall back into indexing a Wilshire 5000 or something.

So this produces net selling for stocks that are not in the chosen benchmark (the S&P500), and net buying in the stocks that are in it. Alas, this produces underperformance in the small-caps and outperformance by S&P500 or other large indexes that might be the target of indexing (such as the Nasdaq 100 (NASDAQ:QQQ), for more growth-oriented managers).

What does it all mean?

Both the low cash levels and the capitulation into indexing have a broader meaning. They mean both complacency and the quitting of trying to outsmart the market, or even considering the fundamentals of what one is investing in.

Over time, small-caps ought to outperform large capitalization stocks. They've done so historically and for good reason - small-cap stocks have intrinsically higher earnings growth rates. It's easier to grow from a small base.

That the market would go against such reality cannot be sustained over a long period. This means that trends which favor large capitalization stocks have to forcefully exhaust themselves.

In the present market, with small-caps not exactly cheap (the entire Russell 2000 trades at nearly 22 times earnings, and that's excluding negative earnings), this means that ultimately the conflict will be resolved though large capitalization stocks dropping "once everyone is in", much like they did back in 2000. (Remember, it was not just tech stocks making up the bubble, Warren Buffett chided himself for not selling Coca-Cola and other similar large capitalization stocks he held when valuations got ludicrous.)

While valuations right now are not comparable to those attained in the 2000 bubble even for large capitalization stocks outside of tech, they're the third highest in history as per the CAPE Price/Earnings (Source: Robert Shiller). And with 1929 and 2000 having been clear exceptions, it's not likely that the levels attained then will be replicated today.

Can large capitalization stocks outperform even more?

Things can always get crazier. Indeed, the kind of large capitalization outperformance we're observing now is still far from the levels we saw back in 2000. The following chart depicts the S&P500/Russell 2000 ratio when compared to its own average over the last 250 days. We can see that things got much farther along back in 2000.

Either way, we can already say we're in a similar environment. In my view, what is prompting the recent market behavior is simply this trend towards more and more indexing, not only overtly through ETF flows, but also covertly through closet indexing of existing funds.

Conclusion

At the very least, expect weakness in small-cap stocks to end up being matched by weakness in large capitalization stocks. At the very worst, expect large capitalization stocks to, at some point, actually underperform small capitalization stocks.

However, this needn't be immediate since things can get crazier and small-cap stocks don't exactly look cheap now. If small-cap stocks plunge again like they did several times this year, though, expect large capitalization stocks to follow.

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 (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.