Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: We’ve talked about how well the S&P 500 has been performing since the correction of last October. But how have small-cap stocks been performing during this time?
Stovall: As you would expect, coming out of a severe correction or a mild bear market, small-cap stocks are trouncing large-cap stocks. History says, but does not guarantee, that they will likely continue to lead in this recovery up into the one-year anniversary in early October. Specifically, while the S&P 500 is up more than 25 percent since Oct. 3, 2011, small-cap stocks are up more than 35 percent. That is fairly consistent with history in that large-cap stocks rose an average of 23 percent in the first six months and small caps gained 30 percent. So if history repeats itself, then we probably could see large caps up a total of 32 percent at the 12-month mark, and small caps could be up 47 percent. As a result, small caps could still have another 12 percentage points to go.
EQ: The S&P 500 did not qualify as entering a bear market because it failed to decline by more than 20 percent during the October low, while the S&P SmallCap 600 index did with a decline of 26.8 percent. Is it possible that small caps are in a new bear market while the large caps are not?
Stovall: That’s true because the S&P SmallCap 600, Russell 2000, and the S&P MidCap 400 did decline by more than 20 percent on a closing basis, so they definitely fell into bear-market mode. It was the Dow Jones Industrial Average, S&P 500, and Nasdaq that did not fall into bear market mode, but experienced a severe correction. However, when you also look to the S&P Europe 350, S&P Global 1200, and other broad benchmarks around the globe, you find that basically every global equity benchmark fell into a bear market mode except for the domestic large cap issues.
So, I would say that small caps are definitely in the beginning of a first year bull market and I would not be surprised if the large-cap U.S. stocks act as if they’re in the beginning of a new bull market.
EQ: Why have small caps historically outperformed large caps during bull markets and recovery periods?
Stovall: It’s primarily because investors usually sell them quickly due to the fear that a bear market is the result of an impending economic decline. Since small caps tend to take it harder during economic declines than large-cap issues. They end up falling more, but as a result, they have more to gain back once the decline in prices has run its course. Basically those companies, sectors, and benchmarks that were priced to go out of business but did not are the ones that have the greatest upside potential.
EQ: Do you have any suggestions for investors on how to play or find opportunities in the small cap market?
Stovall: You can do this in a variety of ways. You can invest in small-cap companies themselves by screening some fundamental characteristics of individual small cap stocks. So some examples could be companies that have cap sizes below $5 billion and have buy recommendations from analysts. If you want to play it simple, you can invest in the S&P SmallCap 600 Index (IJR) or the S&P MidCap 400 Index (IJH). If you’re still a little bit nervous and you’d rather own blue-chip stocks, you might want to consider the Guggenheim S&P 500 Equal Weight (RSP). On that index, every company in the S&P 500 has a similar weighting, and as a result, blue-chip stocks tend to act more like mid-cap issues.
EQ: The market has been expecting a pullback since February, and there are probably many investors waiting for that pullback as their signal to get into the market. Do you think waiting for that pullback is a good strategy?
Stovall: If you have the nerve to wait for a pullback, then it might be worthwhile. Unfortunately, a lot of people don’t have the discipline to sit out an advance in the market. Since World War II, six of the eight rallies off of severe corrections and mild bear markets have seen pullbacks of 5 percent to 10 percent. Of those six observations, there have actually been 10 pullbacks in total and they usually start in month six of the recovery. What that means is if month six starts in early April, and history repeats itself–and there’s no guarantee that it will–that’s usually when we start to become vulnerable to a pullback. No decline has exceeded 10 percent in the first 12 months of a new recovery following severe corrections or mild bear markets, but we’ve had a variety of them between 5 percent and 10 percent, and nine of the 10 started in month six through eight.