In 2012, growth in small-cap stocks has shown positive rewards for bullish investors. This year, they aren’t doing so well. In 2013, the iShares S&P SmallCap 600 Index ETF (IJR) rose 1.1% from February 1st to February 25th, compared to a 3.4% rise in 2012 for the same time period. The Russell 2000 index (RUT) saw a similar change: 3.75% growth for the same time period in 2012 versus 1.2% this year. While less volatile, 2013’s performance suffered last week, when a few economic data points spooked investors and caused the indices to lose around 2.5% in gains at the end of last week. At the same time, large-cap stocks took a smaller hit, but quickly bounced back, and the .DJI is less than 1% below its monthly high, which is itself near the index’s all-time high.
How to Read Small Caps
In the 20th century, any investor who ignored small-cap stocks was a fool. The history books are filled with cases of small-cap companies that grew into the large-cap behemoths that run the economy today; this shift is part of the creative destruction that capitalism thrives on. While large-cap stocks often represent stability, attractive dividend yields, and modest growth, small-cap stocks represent the possibility to reap the rewards of the entrepreneurial spirit that has created trillions of dollars of wealth throughout history.
So no professional investor ignores small-cap stocks, even if the risks are much higher. That risk quotient also makes small-caps underperformers in rough economic times and moments of market doubt and confusion. Easily, the equity markets since the crash of 2008 can be considered one of the most confused and uncertain times in the history of capitalism; the rules of equity performance are just less reliable now than they have been in the past, and so investors have flocked to safety or the perception of safety. This is one reason why the popular financial press touted the value of large-cap dividend stocks at the beginning of 2012: uncertainty in the overall market made these safe and reliable performers a sure bet. Capital flowed to them, both on the retail investor side and the deep pocket hedge fund side, rendering low yields-on-cost and high prices by last summer. The good advice of January became the bad advice of July.
Small caps, on the other hand, remained too risky and did not see the flow of capital they would otherwise when large-cap stocks are overbought, rendering a great buy opportunity for contrarian investors. No surprise, then, that IJR is up over 11%, excluding dividends, from six months ago.
Small Cap Volumes
Now after a steady bull run, worries of small cap saturation may induce a sell-off–or an overbought situation in large-caps could encourage more capital to flow to small-cap stocks. An important indicator of which scenario is likely comes from a metric we have looked at closely in recent weeks: trading volumes.
Trading volumes are down on a year-over-year basis in large-cap stocks; if the same isn’t true for small-caps, it could be reasonable to believe that small-caps have received an overflow of capital and may be currently overbought, with less room to grow than if they were in-line with large-caps. This is an unusual situation where low volumes actually encourage a bullish sentiment.
Unfortunately, making a like-for-like comparison is not very easy and any such comparison could be debated. Do you compare, say, the volume for IJR to that of SPY? Should you compare a basket of small-cap ETFs? Comparing actual volumes in the Russell 2000 is impossible; the names in this index change too much.
IJR has seen tremendous volume growth, from around 246,000 to around 743,000. But this alone says little; demand for iShares products, changes in the ETF marketplace, and other factors could explain this huge growth beyond a stronger bullishness for small cap stocks. A wise investor would do a more in-depth study, looking at a sample of small-cap stocks directly and extrapolating changes in volumes. What’s important is to know what to look for and how to look for it, and changes in small-cap and large-cap markets suggest this is a fruitful source of valuable and profitable information.