The Small-cap Divergence

There has been an extraordinary amount of chatter recently about the Russell 2000. This index of small-cap stocks represents barely 10% of the total market capitalization of the United States. 

So what’s all the fuss about? 

Well for starters, small-caps are often viewed as a barometer for investors’ risk appetites. When bulls are stampeding you will see these names leading the charge. Consider that of the eight years since 2000 that the market was positive, small-caps averaged annual returns of 23%; 40% higher than the 16.4% average return of the S&P 500.

The Russell 2000 had a fantastic 2013, delivering returns of 36.8% which was its best year since 2003. The first five months of 2014 have not been as kind. Small-caps are only down 4.5% YTD, but Friday marked a 10% peak-to-trough decline which hasn’t happened since November 2012.The index just recently closed below its 200-day moving average, also for the first time since November 2012. 

This is small caps’ 36th peak-to-trough decline of at least 10% since 2000, with an average decline of 17.1%. Of the first thirty-five corrections, every one of them were accompanied by large-caps also falling, until now (an average decline of 12.8%).  The thing that has people scratching their heads is why large-caps have been blessed with impunity while small-caps have begun to roll over. The Russell 2000 is 10% off the recent highs and the S&P 500 up 0.12% over the same period. 

What gives?

I’m always hesitant to attach reason to market gyrations, but this development seems worthy of some further thought. 

I’m not so sure I buy the mean reversion argument, after all large-caps were up 32% in 2013, their strongest showing since 1997. You could just as easily say they are overextended and need to correct. 

What I think is more plausible is that for whatever reason, the market started to care about valuation. So, just how expensive are small-cap stocks?

Looking at their averages since 2000, the Russell 2000 is trading at a 24% premium based on price/sales, and a 42% premium based on EV/EBITDA. Conversely, large-caps are trading at just a 14% premium based on price/sales and are actually trading at a slight discount based on their EV/EBITDA. 

Although stocks can remain ludicrously over or undervalued for years, when the market tells you valuations matter, you’d be a fool not to pay attention. 

So where does this leave us?

I understand why Bears are getting excited, however, I’m not ready to say that small-caps rolling over means we are on the verge of something much bigger. Bulls can point to the advance/decline lines of the large-cap and mid-cap indices (which are both right at all-time highs) as a sign that the nasty action in the Russell 2000 is very much contained.

That being said, I think even the most brazen Bulls would agree that if the Russell can’t find some sort of bottom it is likely that the mom and pop names are soon to follow. If the contagion spreads to the Colgate’s and Kimberly Clark’s of the world, we could be in for a long, long year.


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