Sunday, November 16, 2014

The U.S. Stock Market Story for 2014: Bigger Has Been Better

Quick question:  Has 2014 been an up year or a down year for U.S. stocks?  

Chances are good that, if you anchor your view of the market to the Standard and Poors 500 Index or the Dow Industrials, you'd answer correctly that it's been an up year.  Less well appreciated is that the smallest capitalization stocks (IWC) are actually a bit down on the year, even given the recent rally from the October lows.

Indeed, as you can see from the chart above (January, 2 2014 = 100), 2014 returns to date have been a linear function of capitalization, with the largest companies (SPY) showing the highest return, followed by the midcaps (MDY); the small caps (IJR); and the microcaps (IWC).  

This effect is striking, because it shows that only the largest capitalization companies have been making new highs during the current rally.  Why might this be the case?  Large caps with yield, such as utilities shares, have been outperformers, given the crushing of interest rates across the globe thanks to zero interest rate policies from central banks.  Stock buybacks also have been dominant among the large caps, contributing to returns.  Finally, in the wake of global economic weakness and recent U.S. dollar strength, large caps could be benefiting from a flight to perceived stability and quality.

Let's now bring in a different perspective and look at U.S. large caps versus other international stock markets.  Sure enough, we see a similar pattern:  U.S. large caps have made strong new highs, while equities outside the U.S. (EFA) and specifically within Europe (FEZ) and emerging markets (EEM) are actually down on the year.

So, in short, the money has been moving toward U.S. large caps and away from overseas shares and away from the smaller capitalization companies.  From this perspective, the broad asset class of stocks has a major breadth problem.  The rising tide has lifted one boat.  

Nor do I see this dynamic changing since the October lows.  During that period, SPY has gained 9.65%, while MDY is up 9.08%, IJR is up 8.48%, and IWC is up 6.71%.  Healthy increases to be sure, but the pattern of relative returns remains intact.

I've emphasized the strength of the recent rally and the fact that I don't see outright weakness manifesting itself among U.S. stocks.  That being said, should we begin to see diminished interest in U.S. shares--and particularly the large caps--in the wake of an anticipated end to quantitative easing; in response to global economic weakness; and/or in the face of geopolitical turmoil (Russia is a mess and may have every incentive to use the Ukraine conflict to deflect attention from a falling oil market, a weakening economy, and a crashing ruble), then suddenly 2014 begins to look like a broad topping period late in a long-term market cycle.  

That's enough to bring out the bear even in this generally optimistic soul.

Further Reading:  Upside Momentum is Topping