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As Sam Sees It: Small Cap Weakness Is Not a Leading Indicator of a Bear Market

By  +Follow September 19, 2013 4:21PM
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Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.

EQ: The S&P 500 punched through to a new all-time high Wednesday on the Fed’s decision to keep its bond-purchasing program intact. What was your thought on the Fed’s decision and how the market responded?

Stovall: Even though Standard & Poor’s Economics, which operates independently of S&P Capital IQ, had projected that the Fed would probably wait until December to initiate the tapering program, just based on all of the rhetoric going on in the financial media, it probably was regarded as a fait accompli that the Fed would begin its “tapering lite” program in September. So when they decided to do what our economics team said they were probably going to do all along, I was surprised, but pleasantly so.

EQ: Does Fed Chairman Bernanke’s statement about potential additional risks—both with Congress and globally—indicate that the taper could be further down the road than even the December timeframe that S&P expected?

Stovall: That is certainly a possibility. We don’t think it’s the most likely scenario, but if the data continued to come in a little weaker than expected, or if the Fed’s favorite inflationary indicator—which recently pointed to only a 1.3-percent increase—continues to come in below their preferred 2.0-percent target, then I would tend to think that the Fed is likely to continue its bond buying program. Fed Chairman Bernanke is a student of the 1930s, and he remembers how the Fed raised interest rates in 1937 and required the banks to increase their reserve requirements. That threw the U.S. back to recession and the stock market into a mega-meltdown bear market. So I think the Fed would continue to err on stimulating too long rather than too short.

EQ: In this week’s Sector Watch, you examined the relationship between small-cap stocks versus the broader market, and whether small caps work as a leading indicator. Apparently it doesn’t. What did you find that led to this conclusion?

Stovall: I was looking for the answer to the question, “Are small-cap stocks coal mine canaries?” Historians would know that miners used to bring canaries into the coal mines with them because canaries would end up being affected by coal gas more quickly than humans. If upon glancing at the cage, you saw the bird flat on its back, then you knew it was time to leave the mine or you too would be experiencing a similar fate.

So I went back to 1947, looking at large-cap and small-cap total returns for each of the 12-month periods of bull markets. I found that, in general, whenever we have a full bull-market year, both large and small cap stocks do exceptionally well.

Also, in each of the six years of bull markets going back to 1947, only in one year (year five) did small-cap stocks underperform large caps, rising only 18 percent versus the average of 24 percent for large caps. However, should the bull market make it to year six—and only three of the 11 did—we ended up seeing a late-cycle surge for small-cap stocks, rising an average 33 percent versus 27 percent for large-cap issues. So in a nutshell, what I’m saying is, if we continue to bask in the glow of a bull market, then small caps are likely to do as well, if not better, than large caps. As a result, they don’t end up being a reliable canary in the coal mine.

EQ: Where do you think the idea of using small caps as a leading indicator originated from?

Stovall: I think the old saying is that when the seas get rough, sailors prefer a larger boat. So the same can be said about the stock market. If times begin to get challenging, investors are more likely to drift toward the larger-cap stocks because their market share is larger, they have a larger reach, usually have better contracts with suppliers, are not as dependent on letters of credit from the bank, and so on. Therefore, larger companies can end up surviving downturns better than smaller ones.

The data show that, while all this is true, it would probably take place in the midst of a new bear market and not as an advanced signal that a bear market is coming.

EQ: Are there any predictive powers when analyzing the correlation of small cap stocks and the broader market?

Stovall: Yes, I did feel that while small caps can’t necessarily tell you when a bear market for large caps is likely to ensue, you can at least know when small caps might end up lagging large cap performances. I did this by looking at the relative strength—meaning the performance of the Russell 2000 divided by the performance of the S&P 500—and finding extremes in small cap performances.

Back in May 1983, we had the relative strength of the Russell 2000 climb to more than two standard deviations above the mean before it eventually fell to more than two standard deviations below the mean in 1999.

Today, we are more than one standard deviation above the mean, so the implication is that relative to large cap stocks, small cap stocks have probably seen the best days already, but there’s no guarantee that they are likely to top out anytime soon. Like in 1983, they might have to climb above that two standard deviation level before running out of steam.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.


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By  +Follow September 19, 2013 4:21PM
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