Market Overview: Small Cap Struggles

Posted on October 10, 2014 by David Laidlaw

Aside from Alibaba’s Initial Public Offering (IPO) and the Scottish independence vote, little of interest occurred in the market during the 3rd Quarter. The S&P 500 increased by 1.13% representing the seventh quarter in a row when large capitalization stocks appreciated in value.

The underlying US economy continues to grow and produce jobs at a steady rate. As of this writing, unemployment dipped below 6%—to 5.9%—for the first time since July of 2008. In September, the economy created 248,000 jobs and has added almost 230,000 per month over the prior six months.

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Yields on 10-year US Treasury Notes have also fluctuated within a narrow range from 2.4-2.6%. Strong employment reports tend to cause the yield to rise while low inflation data or deflationary numbers from Europe push yields down.

Compared to the broader large capitalization indices, prices for small capitalization stocks and international equities have been much more volatile and losses are mounting. The Russell 2000, the most widely used benchmark for small companies, lost almost 7.4% in value during the quarter and is down 4.4% so far this year. While not as fundamentally expensive as sectors within the technology universe (see below), small stocks are historically expensive relative to large companies. In aggregate, the Russell 2000 sells for a price/earnings multiple of 62.0 as of September 30 according to Bloomberg’s analysis of the iShares ETF that tracks the index. Therefore, the average small cap investor is paying $100 for every $1.61 in corporate earnings. This valuation level suggests that small capitalization underperformance will continue.

International stocks also performed very poorly during the 3rd Quarter. Foreign companies, as measured by the MSCI EAFE Index, decreased by 5.4% during the quarter and 1.4% year-to-date. Some of the weakness has been due to strength in the US Dollar versus the Euro and the Yen. International companies are generally much less expensive than small capitalization US stocks, but Europe’s economy is not growing and there is continued concern that China’s economy will grow more slowly than it has over the past 20 years.

We expect that this volatility in small caps and international stocks presages increased fluctuations in the broader markets, especially as the Federal Reserve ends its program of Quantitative Easing (QE3). From December of 2012 until December 2013, the Federal Reserve bought $85 billion worth of US Treasuries and mortgage-backed bonds every month. The central bank then began reducing this stimulus starting in January of this year by ten billion dollar increments. The Federal Reserve is scheduled to purchase its last installment of bonds this October. As the availability of credit decreases throughout the economy, the potential for stock market losses increases over the near term. 

Monetary policies have been so stimulative for so long that it will be interesting to see the impact of the termination of the bond purchase program. Unless economic expansion continues at a brisk enough pace, asset prices may wobble as monetary stimulus is removed.