Investing in the Small Cap Surge

If you can’t sell abroad, sell at home. That’s what American companies are doing in the face of a continuing slowdown in foreign demand for U.S. made goods. It isn’t that the goods are no longer as valuable; it’s more that foreign money is no longer as valuable, and foreign buyers just can’t import as much.

So America is turning to its own domestic market for growth – and it is getting it in spades, as evidenced by the stellar performance of small capitalization companies versus their large cap counterparts. While almost all sectors of the U.S. economy have been growing in leaps and bounds since the 2008-09 recession ended, small caps have pulled far ahead of the large, since the large cap space includes international giants who derive a substantial portion of their revenues from ailing foreign markets.

Small caps, on the other hand, are focused on the robust activity back home. More nimble, they can adjust to changing trends in consumerism more quickly. And given their smaller size, even a small contract or deal can lift their revenues significantly on a percentage basis. These agile speed boats are running circles around the sluggish large cap tankers.

Yet there are times when this small size can be dangerous to small caps, especially if they are caught in a rising storm. What lies in store for the small caps? Should investors keep in tow? Or abandon them for the sturdier, more survivable large caps?

The Trend Favors Small Caps

Since the depth of the economic crisis in the spring of 2009, small caps have enjoyed a fantastic bull run. They’re always the first ones out the door when you let the dogs out, while the larger, older dogs take their sweet time.

Comparing the Russell 2000 Index (NASDAQ: RUT) of American small cap stocks to the Russell 1000 Index (NASDAQ: RUI) of large caps, the graph below shows how the small caps (black) have climbed 170% in the past five years, versus the 95% rise of the large caps (beige).

Source: BigCharts.com

“The main driver of small-caps is the cyclicality of the market,” Patrick Moonen, senior strategist at ING Investment Management, informed Bloomberg. “What are the economic prospects and how are risk aversion or risk appetite evolving? Both factors were clear tailwinds for small-caps so far this year.”

In other words, with fear and uncertainty lifted, investors’ regaining of their appetite for risk has favored the small caps. Many analysts are thus concluding that the equity bull market is set to keep running at least another year, as Moonen elaborates:

“We have a window of three to four months where we have improving fundamentals and low or no risk of [stimulus] tapering. We are in a sweet spot in that we don’t see any major hurdles before the end of the year, now that the U.S. fiscal situation is out of the way.”

History tells us that similar energetic runs in the small cap space have often signaled the start of something big. They certainly got the party started in 1991 and 2003, ushering in two fantastic bull runs that lasted nine years and four years, respectively. “Historically,” Donald Selkin, chief market strategist at National Securities Corp, confirms to Bloomberg, “the trend has been for the small-caps to hand the baton off to the large-caps.”

And the large caps did indeed follow suit in a big way, with the Dow Jones Industrial Average of 30 large cap stocks climbing from 3,000 to 11,500 for a stellar 283% rise in the first case, and from 7,500 to 14,000 for an 86% gain in the second. Since the last recession ended in 2009, the Dow is already up 138%.

Dark Clouds Gathering?

Yet we must keep in mind that the small caps have already been roaring along for well over four years now, and their run is no longer fresh.

Finding the small cap space a little too hot to handle, analysts cite dangerously high valuations as a flashing dashboard light indicating the equity engine is overheating. Where the Dow Jones index currently reads a modest average valuation of 14.7 times estimated operating earnings, the Russell 2000 index of small caps reached a price-to-earnings ratio of a screeching 27.5 times.

“It seems a little too optimistic,” Steven DeSanctis, Bank of America Corp strategist for small-cap equities, cautioned to Bloomberg. “At the start of the year, valuations were attractive. Not so much today,” he fears, predicting the small cap Russell 2000 index to end the year at 1,100, or 1.6 percent lower than last week’s close.

Lawrence Creatura, fund manager at Federated Investors Inc., is equally concerned. “Based on the earnings that we have so far, it appears that economic growth is not as robust as what we hoped for at the beginning of the year,” he suggested to Bloomberg. He believes that the small caps have run too far ahead of themselves and that the large caps will not necessarily follow them much further this time around.

As depicted in the graph above, when corrective pullbacks do occur, the small caps always correct more (red) than the large caps do (blue). Their smaller balance sheets and usually larger debt burden relative to assets make small caps more susceptible when the economy slows.

Protective Measures

If even the experts are divided over the future of the equities market – some seeing smooth sailing ahead, while others forecasting a stormy correction – what should we ordinary investors do?

For one thing, we need not abandon ship. The Federal Reserve is still towing the markets along, and it is not about to let go of the stimulus life-line anytime soon. Its monthly bond purchases are still on tap, and low interest rates will remain unchanged for at least another two years.

But the recent run up in the markets and high valuations of the small caps are hinting that we should protect what we have won so far. One often-used device is to split an investment across two equity ETFs – 50% in a large cap fund, such as the SPDR S&P 500 ETF (NYSE: SPY) and 50% in a small cap fund, such as the SPDR S&P 600 Small Cap ETF (NYSE: SLY). You then simply trade them against each other, restoring the 50-50 balance after it has moved out of sync a few percentage points or so.

Known as relative value trading, the idea is to sell a little of the ETF pulling ahead to buy the one lagging behind. As the bull run continues and small caps outperform the large, you would sell a little of your small cap ETF and buy a little of the large cap. In so doing, you’d be moving your assets from the higher risk vehicle to the lower risk one as the market heats up.

Then, after a corrective pullback, when the small caps underperform the large, you would simply move funds back from the large cap ETF to the small. The end result is you will have sold high and bought back low. And isn’t that the whole objective?

While looking to the small caps for an offensive gain, we mustn’t neglect to periodically store our winnings in the relative safety of the large caps. A nice balance between the two allows us to keep participating in the stellar bull run while still protecting our gains as we earn them.

Joseph Cafariello

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