The Decline of Small Cap Stocks

What Investors Should Know About This Small Capitalization Equity Trend

The Decline of Small Cap Stocks
July 16, 2014

Small Cap stocks, as represented by the Russell 2000 index, went through an unusual period during April and May of 2014. While the Dow and S&P 500 hit record highs, the Russell 2000 experienced what was arguably a correction – dropping 10% from the high values in March. The relative divergence between the S&P 500 and the Russell 2000 was approaching record territory.

Economists were split about what this decline meant. The pessimist camp was concerned that the decline was a harbinger of a similar decline in larger caps and across-the-board market decline. Optimists expected that improved economic growth would help the small caps recover.

Gary Bradshaw of Hodges Capital gave the optimists ammunition, according to Forbes, stating that, "Large caps are flush with cash, and we think there's going to be a lot of acquisitions of small caps."

One month later, who appears to be right? At this point, the optimists have the lead.

The Russell Index has climbed back to recover approximately 75% of its drop from its peak value in March, representing a 4.3% increase for the month of June (as of June 19th). It has pulled back into positive territory for year-to-date growth at 1.68%. Economic growth has been improving compared to the dismal first quarter of 2014, but it wouldn't seem to be robust enough to warrant this increase. Acquisitions do not appear to have been a major driver either. So what happened?

One of the best explanations is that the Russell 2000 experienced an overdue correction, thanks to an unusually good 2013 and corresponding overvaluation and/or unrealistic expectations.

When assessing overvaluation, the place to start is usually the P/E ratio. The contrast between the forward and trailing P/E ratios can be insightful – since the trailing P/E ratio is based on 12 months of performance and the forward P/E is based on estimates of upcoming earnings.

Comparing the current trailing P/E ratios to last year's (using valuations from the Wall Street Journal), the Russell 2000's value on June 13, 2013 was 59.12 but has since skyrocketed to 82.71. Sounds like trouble, doesn't it? Not really, considering that it was an even higher 101.65 on April 25th. The correction is already beginning to bring the trailing P/E values back to Earth.

Meanwhile, the forward P/E's show a similar return to earth (again using Wall Street Journal data). At the beginning of 2014, the forward P/E for the Russell 2000 was 24, compared to 15.7 for the S&P 500. On May 16th, as the correction neared the lowest point, the Russell was at 21.5 and the S&P 500 at 15.3. As of June 13th, the Russell 2000 was at 19.23 and the S&P 500 is at 16.38.

A relatively large number of small cap stocks had been missing earnings estimates in the first quarter, eventually correcting the P/E as expectations settled into more realistic territory. Most analysts are predicting economic growth to continue at a modest pace (the Fed revised 2014 GDP downward last week, to just above 2%) , and based on the Russell 2000's June results, investors believe the small cap corner has been turned.

Small Cap stocks are a useful growth component of a diversified portfolio, and it may be wise to stick with them over the long haul. If you are trying to maximize growth through increased small cap activity, keep a close eye on the second quarter earnings numbers of your small cap holdings to see if they are out of line with the estimates.

Let's hope the optimists continue to prevail and the Russell 2000 makes its way back to sustained growth.

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