Are Small Cap Stocks About to Catch Up More?

Small Cap Stocks

Whenever a type of stock or stock investing strategy has been running cold, people expect a comeback. Talk is picking up about small cap stocks coming back soon.

There is an overall rationale in the stock market that believes that underperformance in itself will beget higher performance, and that underperformance is somehow a condition that is in need of correction, where things get out of balance on the downside and natural forces will one day step in to rebalance things.

It is interesting how we come up with such things and it turns out that we assume that there is a natural reversion to the mean going on, even though such a view conflicts with what actually goes on in the stock market. As long as we don’t think too much, and preferably not think at all, this view can be sustained, although if we step back and ask ourselves how this is supposed to happen, we just assume it will and then start hoping.

Hope alone won’t get you too far though, and if we can’t demonstrate that are hopes are sufficiently valid and reasonable, then the only sensible thing to do is to abandon the idea in favor of ones more in concert with the way stocks actually do move.

Small-cap stocks are still viewed as being more volatile, more like a growth stock than your average larger cap stock, but this is an overgeneralization, and volatility doesn’t correspond as much to size as it does to how much the future is priced into a stock.

Those stocks with more future priced in, like technology stocks tend to have, will both allow a stock to grow faster when the view of the future is expanding overall, during the good times, and also may these stocks to give back more when the view of the future dims.

When we group stocks together in indices like we do with the large-cap S&P 500 and the small-cap S&P 600, we have an opportunity to compare how a broad range of each type are performing against one another, and when we do that these days, we do see the smaller cap stocks lagging pretty significantly. If the smaller stocks are supposed to be more volatile and have a higher alpha than large caps, this just isn’t happening these days.

It’s not that the S&P 600 has done all that badly in 2019, and the index has grown by 17% year to date, which is a good year by most accounts, but not compared to this index’ big brother, who is beating them by 9% this year.

Even more notable is the fact that the small-cap index is still 10% away from its high of last August, where the index started to break down, several weeks before the broad market did. We are left with the full measure of the additional volatility that people expect with smaller stocks while the upside remains dampened. This is not what we want to be seeing with a group of stocks and the fact that this remains does not in itself suggest in any way that we’ll see a reversal of this.

Since many people don’t need a reason or explanation, and just will make their predictions independent of whether they really make sense or not, this perceived lack of performance is expected to just improve, out of thin air perhaps.

Given Our Money is On the Line, We Need to Make Sure We are Using Our Heads

Since we are looking to put real money on the line with our visions of the future, it is quite important that we base these visions on some sort of rationale. We need to start by asking ourselves what causes small-caps to underperform and what it would take for them to start overperforming.

In particular, we need to see whatever is causing this to turn around, and not just at the level of hope but this actually manifesting itself in stock prices and index values. We can theorize all we want but unless our beliefs start to translate into reality, we will remain at the level of hope and not even start to be rewarded for them.

We can think of the movements of stocks in terms of confidence, and regardless of whatever things that people look at in influencing the price of stocks, it will be expressed in degrees of confidence, which can be measured simply on a chart. Investors have been more confident about large-cap stocks in 2019 for instance and this has shown itself by their going up by 26% instead of the 17% that the small-cap index has bettered itself by this year.

If this is to change, the relative confidence in each of these stock types will have to change as well. We can pontificate away on this but we know for certain that we’re going to need something substantial to turn the tide, and whatever reversal that may happen will need to start somewhere.

This means that if we really are going to be favoring smaller cap stocks soon, as many believe, we will first need something to cause it, and we’ll also need to see it actually starting to happen, in enough of a way that causes it to build up enough momentum to be able to say that this is more likely than not, which is the minimal threshold for action.

We never want to be going with anything that is less probable when we invest, and the only time this makes sense is when the payoff is large enough that we can afford to be wrong more than we’re right, like certain options trades for instance. Migrating to small-cap stocks is nothing like this and without their comeback being at least probable, we will be putting ourselves in a position with a negative expectation, which always means an expected loss on balance.

A lot of people are very confused about how the stock market works in the first place, where the majority of their thinking is way too out of touch. Stock prices always boil down to one thing, the outlook of the market, and while many things shape this outlook, we can’t just look at a few of them, pretend that this is the gold ring, and then look to apply this broken theory to small-caps and expect to be right very often.

While there are a number of things that these people use to try to understand stock prices, all of the ones that we may call external depend to some degree on the view that the market will naturally gravitate to their beliefs, where if we’ve deemed a stock overvalued it will decline, and vice versa.

The problem with this approach is that this is not how things work in the real world, producing a variety of states of disharmony with our analysis, and due to the narrowness of our perspective, we are left with nowhere else to go besides expecting that these divergences will disappear and reverse.

The classic example of this is valuing companies by their current earnings, when the market is valuing earnings potential much farther into the future, and price the stocks according to this future potential. We’re just looking at the next year so depending on the brightness or the dimness of the future of the stock, our calculations will be off by that much, and we then see this divergence as being evident of something wrong with the market rather than something being very wrong with our approach.

Small-Cap Stocks Look Dim Overall, But Some Look Pretty Bright Indeed

The market is therefore seeing a brighter future we could say with the big index and things aren’t seen as quite as bright with the smaller stocks, overall at least, although we need to remember that even though most small-cap stocks may lack zest, some have plenty of it and even more than large cap stocks do on average.

Just because the small caps are lagging does not mean that they are all unworthy, this just means that a collection of them such as those held in the S&P 500 small-cap index or any broad smaller cap index that has underperformed large caps have not shown themselves to be very worthy right now.

There is actually no good reason to think that small-caps will even narrow this gap anytime soon, simply because this isn’t happening. If we think it should be happening, and it is not, we are simply wrong about this right now and need to at least wait until there is some real basis for us to be right before we even take such thoughts seriously.

Ultimately, it doesn’t even matter why smaller-cap stocks are lacking, because regardless of how we try to explain this, we are still left with the fact. Momentum needs something meaningful to cause it to reverse, but if it is not reversing, the best we can do is speculate on what would cause this to change, and sit back and watch to see if this happens for any reason.

Some of this impetus toward smaller caps comes from people picking certain small-cap stocks that may be doing well right now, and we always have those. Some people see these things and think that small-caps may be making a comeback, but if you seek to understand what’s going on with the small-cap market overall, that’s what you need to be looking at, things look as dull as ever on that front if not more so.

The rally with the S&P 600 in 2019 only really lasted for the first 6 weeks of the year, which it has spent the rest of the year trying to get past. We’re finally over that mark but only by a slight amount, and there just isn’t a good reason out there to cause us to think that this lagging won’t just continue indefinitely.

Should people move to small-caps enough to the degree that it started to outperform large caps, which could indeed happen at some point, now we’ve got something that we could at least hang our hopes on, but we at least need some sort of hook to do this, and it just isn’t there right now.

Should we genuinely be interested in small-caps, and we also are interested in something that is growing faster than the S&P 500, there are some funds out there that have been delivering this, such as the Virtus Small-Cap Sustained Growth Fund which has been beating the crap out of large cap stocks for quite a while.

This fund is up 263% since the start of 2016, versus the 53% gain that the S&P 500 has enjoyed over this time. Small caps are still known for their growth even though they haven’t been growing all that much lately overall, but the stocks in this index sure have, and they have been chosen on that basis in fact, what we need to be doing if growth is what we seek.

This fund has also outperformed the S&P 500 in 2009 as well, generating a 38% return this year so far, compared to the 26% with the S&P 500 and the 17% that the small-cap S&P 600 has brought us.

Some might think that this small-cap growth fund would be much more volatile on the down side as well, but during the pullback last year, which for small caps lasted not just from October to December but from August to December, this growth fund had the same maximum drawdown of 20% that the S&P 500 had.

People overestimate the risk of growth funds overall, which results from their not properly accounting for both the benefits of a greater upside and the potential for the downside together. By their focusing on the negative and ignoring the positive, this leads to them being scared away from the good stuff like this in favor of more mundane approaches which yield risk/return ratios that are greatly inferior.

We focus so much on stock indexes that we even seem to forget what investing is all about, which is to seek out potential for gain in a sufficiently safe way. This is not a Johnny Come Lately fund, and has consistently more than doubled the return of the S&P 500 throughout this entire 10+ year bull market and has done so in a way that has not presented any more risk.

It also held up well during the market collapse of 2007-09, and this fund went down less than big caps did in fact, and also recovered much more quickly. In terms of growth, large caps have tripled in value since the bottom of this, but it took a decade, but this small-cap fund tripled in just the first two years and has now grown by over 7 times now.

The reason why more people don’t look to these superior funds when they invest is that they remain very much confused about the merits of such things and just cast them off as being too risky without any merit. If you just throw out ideas without really looking into them and just follow the crowd, the crowd is often wrong and this in itself has no virtue, especially in investing where the common view is very dumbed down to the point of being quite dumb indeed.

It is not that small caps are ripe to take off generally, not now at least, but the right small caps have been very ripe for a very long time, as long as we look at the ripe ones and not the ones that are rotting on the tree. Mixing in rotten fruit with our good ones is also not a good way to get a good harvest, and those of us who select our fruit based upon their quality will be in a much better position to enjoy the fruits of our investment labor.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.