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Will small caps survive over the long haul?

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In a year that’s been generally kind to all sorts of stocks, small caps have been possibly stronger than any other category. In fact, the Standard & Poor’s 600 — the small-cap little brother to the venerable S&P 500 — touched a record during intraday trading last week, although the index lost a little ground before the market’s close. It’s up 14 percent since June, and eight of its ten sectors have returned more than the same sectors in the S&P 500.

The best-known of the small cap indexes, the Russell 2000, has also shown a similar amount of strength recently. It’s up 13 percent since June, a return that’s better than the mark put up by either the Dow Jones Industrial Average or the S&P 500. And that was after the Russell 200 had risen 12.1 percent in the first three months of this year.

Will that outperformance continue? There are a couple of warning signs in the air, signaling that small caps may start to lose some steam before long.

Small caps are now more expensive than large caps. The entire market is trading at a discount to its historical norms right now, but large stocks appear to be trading at bargain prices compared to smaller ones. According to data compiled by S&P Capital IQ, the S&P 500 collectively is trading at a price-to-earnings ratio of about 14, as opposed to a historical median of 18.2 since 1995, a difference of about 30 percent.

The S&P 600, though, has a P/E of 19.9 as opposed to a historical median P/E over that same time frame of 21.4. For the small-cap index, then, the current difference is just 7.5 percent. Small-cap P/Es are much closer to historic norms than large-cap P/Es are.

Interest rates will be low for a while yet. The conventional wisdom is that stocks thrive when interest rates are rising, but research from Fidelity indicates that small cap stocks do especially well. For example, in periods when 10-year Treasury rates have been rising, small caps have outperformed large caps by 0.56 percent, but when 10-year rates have fallen, small caps have underperformed large caps by 0.59 percent.

That’s a tailwind that’s not likely to be consistently available to small caps for quite some time. When Ben Bernanke announced the third round of quantitative easing last week, he also indicated that the Fed is unlikely to raise interest rates until at least 2015. So while the Treasury bond rate is at historic lows, it’s not likely to show a lot of upward movement any time soon.

Small caps do better in times of strong GDP growth. Fidelity’s research also shows that small caps tend to thrive during periods of stronger GDP growth. For instance, from the beginning of 1980 through the end of 2011, whenever annual GDP growth averaged more than 2.5 percent per 12-month period, small-cap stocks returned an average of 16.57 percent. But during 12-month periods over that same time frame in which GDP growth has declined, small-cap stocks have lost an average of 3.03 percent per year.

We don’t appear to be headed for another period of negative GDP growth, but the numbers have been coming in at less than 2.5 percent lately, and don’t appear to be poised to grow much higher than that. The U.S. posted GDP growth of 1.7 percent in the second quarter and has exceeded 2.5 percent in just one of the past eight quarters. In a low-growth environment, it might be difficult for small caps to outperform.

The fiscal cliff might hurt small caps more than other stocks. Unless direct action is taken to prevent it, Congress has scheduled some automatic budget cuts and tax increases to happen at the end of the year, what’s become known as the fiscal cliff. Should we reach that position, it could have harmful effects on all aspects of the economy, but small caps may suffer more than other stocks.

Small caps often have a hard time weathering tough economic times, and are prone to wider swings in share price than mid- or large-cap stocks. While the S&P 500 was dropping by 2.1 percent from April through July, the Russell 2000 fell by 5.1 percent, or more than twice as much. If the fiscal cliff does indeed spell trouble for the U.S. economy, small-cap stocks could bear the brunt of the damage.

Most of these reasons illustrate a truism that has been long known in the markets: Small caps are riskier than larger stocks. Small caps generally don’t have the diverse revenue streams or stable cash flows that bigger companies have, which makes them more vulnerable to difficult economic times. And with lower trading volumes, they also suffer wider swings in share prices than larger stocks.

So in a time of economic headwinds, small caps often fare poorly. If the economy fails to strengthen much over the coming months, the recent rally in small caps may quickly peter out.

For more from Tom Nawrocki, see:

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