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It Was a Very Good Year – For Small-Caps

20 December 2013 in Trading Ideas

It’s plausible that the unexpected could happen in the financial markets, but with only about six trading days left in the year, it seems pretty safe to say that the outperformance of small-cap stocks over large-caps is going to hold through the year’s end.

The large-cap S&P 500 has increased 27% in 2013. A fine performance, some would say, until you check out the 33.5% rise exhibited by the small-cap Russell 2000.

Our own Small-Cap Stars motif has gained 26.1% since its inception on March 6, 2013, and is up 3.2% in the past month. In the past month, the S&P 500 has gained 19.2% since the motif’s inception and has risen 1.4% in the past month.

While it’s often pointed out that small-caps tend to outperform large-caps during sustained market rallies, it’s commonly forgotten that there are some fundamental reasons for this – namely, the smaller guys are growing faster.

small-cap starsAccording to a note last month from Bank of America Merrill Lynch, profits of small-cap firms were on track to rise 14% in the third quarter from the previous year, the fastest growth since the second quarter of 2011.1

Third-quarter small-cap sales grew 7.1% from a year ago, the best growth since the first quarter of 2012.

As the note indicates, that growth stacks up particularly well against the 5.3% profit growth seen from large-cap companies in the third quarter. And while small-caps normally exhibit faster earnings growth than larger companies, as well as greater volatility, these latest numbers represent the widest gap between small-cap and large-cap earnings growth since the third quarter of 2010.

Of course, as small-cap investors turn to 2014, the immediate questions are: can this profit-growth continue and, if so, will it favorably impact the performance of small-cap stocks?

Nobody knows for sure, but a useful piece of information was offered by Bloomberg’s Adam Johnson, who reported that strategist Chris Verrone determined small-caps tend to outperform large-caps during quarters when the Bloomberg US Financial Conditions Index is positive. Essentially, small-caps do well when economic conditions that are conducive to lending coincide with favorable business environments.2

Smaller, growth-oriented firms are obvious beneficiaries, according to Verrone.

However, while the Financial Conditions Index was recently at a 20-year high, the uptick in interest rates has led to an interesting reversal of fortune between small-caps and large-caps. Since October 23, when the 10-year Treasury yield has gone from 2.5% to 2.9%, the S&P 500’s gain of 3.2% has exactly doubled the Russell 2000’s gain of 1.6%.

Fast forward to Wednesday’s Fed announcement that it would begin tapering its bond-buying program, a move that could contribute to pushing interest rates higher. The S&P 500 finished up 1.65%, while the Russell 2000 gained 1.33%.

Discerning investors will need to determine whether those trends are a coincidence or a sign that small-cap investing should carry a heightened sense of caution.

1Alexandra Scaggs, “Small-Cap Profits Outpace Large-Cap Peers,” WSJ.com, Nov. 14, 2013.

2Adam Johnson, “Bank Stocks, Small-Caps May Be Headed For Happy New Year,” Bloomberg.com, Nov. 26, 2013, http://www.bloomberg.com/news/2013-11-26/bank-stocks-small-caps-may-be-headed-for-a-happy-new-year.html, (accessed Dec. 18, 2013).

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