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October 11, 2014

Don't Give Up On Small Cap Stocks Yet

It has not been a good year for small-cap stocks. As of yesterday’s close, the Russell 2000 index was down 4.78% year-to-date. In contrast, the larger-cap Russell 1000 index was up 7.72%. We’re seeing similar comparisons with other indexes as well. For example, the S&P SmallCap 600 was down 4.99%, whereas the S&P 500 index was up 6.52%. (Obviously, these numbers will be lower once data reflecting today’s decline is published.)
Valuations have been blamed as the reason why. Small-cap stocks were expensive relative to large-cap stocks. They still are. S&P Capital IQ calculates the SmallCap 600 as trading at 22.1 times trailing 12-month (TTM) earnings, versus 26.3 at the end of 2013. In contrast, the S&P 500 is trading at 16.8 times TTM earnings, versus 16.9 at the end of 2013. Arguably, in the background, other concerns (e.g., the tapering of bond purchases by the Federal Reserve, geopolitics, the length of the bull market, etc.) are also playing a role in causing small caps to lag.
This is not the first time small-cap stocks have underperformed large-cap stocks, and it likely won’t be the last time either. As John McDermott and Dana D'Auria discussed a few months ago in the AAII Journal, small-cap stocks only beat large-cap stocks on an annual basis about 50% of the time between 1926 and December 2013. The size premium realized by small-cap stocks comes from their higher volatility. Small-company stocks experienced a standard deviation of 32.3% between 1926 and 2013. Large-company stocks had a lower standard deviation of 20.2%, according to the 2014 Ibbotson SBBI Classic Yearbook. (Standard deviation measures the range of values above and below average for a set of data. Larger values indicate greater variability.)
The volatility has come down a bit over the past few decades. Ibbotson shows a 23.2% standard deviation for small-company stocks over the period of 1972 through 2013. Large-company stocks have a standard deviation of 18.0% over the same period.
Volatility, of course, is relative to the time period you own an investment. All the statistics in the world don’t matter much if your portfolio is falling in value and your emotions are yelling “Sell! Sell! Sell!” This is where an understanding of market history and good amount of patience is helpful. Ibbotson says small-company stocks have been the highest-returning asset 44 times out of all five-year rolling periods between 1926 and 2013. Large-company stocks have had the highest returns 23 times over the same rolling five-year periods. The ratio is not dramatically different over 10-year rolling periods: 46 times for small-company stocks and 20 times for large-company stocks. Extend the time frame out to 20-year rolling periods and the difference is very stark: small-company stocks outperform 59 times versus nine times for large-company stocks. Put another way, the ratio widens from 1.9:1 to 6.6:1.
Patience with small-cap stocks is rewarded. Being patient does come at the expense of coping with greater price volatility. You need to balance your desire for capital appreciation against your short-term financial needs and your emotional tendencies. You are always better off giving up some upside return instead of taking on more price volatility than you can withstand and panicking as a result. One compromise is to hold both large-cap and small-cap stocks. The two have a historical correlation of 0.73 over the past 41 years—a sign they don’t always move in lockstep. An alternative is to follow a tactical approach, though doing so comes with even greater downside risk than maintaining a constant allocation if your timing is wrong and/or you do not act in a prompt enough manner.
The Week Ahead

The U.S. bond markets will be closed on Monday in observance of Columbus Day. The U.S. stock markets will be open, however.
I will be speak to our Milburn, NJ Education Group on Tuesday.
Taxes are due on Wednesday for those of you filed extensions on your 2013 taxes. Now is also a good time to start planning for 2014 taxes, including any planned IRA contributions, IRA distributions or Roth IRA conversions.
More than 50 members of the S&P 500 will report earnings next week, with many of them being mega-cap companies. Included in this group are Intel Corp. (INTC), JPMorgan Chase & Co. (JPM) and Johnson & Johnson (JNJ) on Tuesday; American Express Company (AXP) on Wednesday; Goldman Sachs Group (GS) and UnitedHealth Group (UNH) on Thursday; and General Electric (GE) on Friday.
Wednesday will feature the week’s first economic reports of note: The September Producer Price Index (PPI), September retail sales, the October Empire State manufacturing survey, August business inventories and the Federal Reserve’s periodic Beige Book. September industrial production and capacity utilization, the October Philadelphia Fed Survey and the National Association of Home Builders’ October Housing Market Index will be released on Thursday. Friday will feature September housing starts and building permits and the University of Michigan’s preliminary October consumer sentiment survey.
Five Federal Reserve officials will make public appearances. Chicago president Charles Evans will speak on Monday. Philadelphia president Charles Plosser, Kansas City president Esther George, St. Louis president James Bullard and Minneapolis president Narayana Kocherlakota will speak on Thursday.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

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