Saturday, May 10, 2014

Underperformance of Russell 2000 Small Cap Stocks: What Does It Mean?

A number of people have been focused on the relative underperformance of small cap stocks versus large caps.  Indeed, while the Dow Jones Industrial Average (DIA) touched new highs this past week, the Russell 2000 Index (IWM) was trading near multi-month lows.  Particularly weak have been microcap shares (IWC).

As we can see from the chart above, tracking 100-day relative strength of the Russell 2000 and S&P 500 Indexes since 2000, it is not at all unusual for the smaller caps to go through extended periods of underperformance.  While the current relative relationship is oversold, it is not at the extremes we witnessed in May, 2011; October, 2008; or May, 2002.  Interestingly, those very oversold points in the relative relationship ended up heralding very good long-term buying opportunities for stocks.

If we just look at 100-day periods of relative outperformance versus underperformance of the Russell 2000 Index, what we find is that forward returns for both Russell and S&P have been superior following small cap underperformance largely due to the influence of the above three instances.  Occasions when we have been at points of Russell underperformance similar to the current level include March, 2004; April, 2006; April, 2010; and March, 2012.  Those were corrective periods--but not necessarily precise market lows--that ended up being good times to be long stocks for the longer term.  Similar occasions also include March, April, July, and October of 2007--a period when stocks were topping out longer term.

Bottom line is that:  a) the underperformance of Russell 2000 stocks has tended to occur during corrective market periods; b) such periods have often led to superior longer-term returns; and c) underperformance similar to current levels can become greater underperformance during true bear markets before they lead to superior returns.  Given that the current underperformance is occurring in a low VIX environment, it is not clear to me that we are witnessing a repeat of 2011, 2008, late 2007, or 2002.  The underperformance of small caps has not been a precise timing measure for stocks but on average has occurred during periods of risk aversion that have yielded positive forward returns for investors over the medium term. 

Further Reading:  Risk Aversion in 2006