Don’t Sweat The Small Caps [iShares Russell 2000 Index (ETF), Vanguard Index Funds]

etfsDavid Fabian: One of the more persistent themes since stocks took off in April has been the underperformance of small cap stocks. Specifically market experts have been overly fixated on the iShares Russell 2000 ETF (IWM) when compared to large cap indexes such as the SPDR S&P 500 ETF (SPY) or PowerShares QQQ (QQQ).

The crux of the issue is that large-caps continue to hit new all-time highs, while this widely followed small cap index is languishing near the flat line for the year. Depending on which two indexes you compare, there is anywhere from an 8-11% disparity in total return this year.

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That’s a big margin of underperformance when you consider that the expectation is for small caps to outperform in a bull market. Smaller companies tend to benefit during cycles of economic prosperity and lead on the upside, which is why many experts are concerned that IWM is a warning signal for the end of this rally.

Some will point to the rich valuations of the Russell 2000 Index, which is currently trading at a price/earnings ratio of 75. The S&P 500 Index is trading at a much lower price/earnings ratio of 19.54.

Others will point out that the technical price pattern of IWM is unhealthy, which will drag the rest of the stock market down with it. This ETF has been flirting with its intermediate and long-term moving averages all year.

While I share many of these same concerns, the fact of the matter is that it doesn’t appear to be adversely affecting the broader market as a whole to the extent that the bears would lead you to believe. We have been watching this divergence for nearly four months and it has yet to derail large-cap momentum.

Most investors have seen this evidence and fall into three categories:

  1. Those that are buy-and-hold for the long-term and are going to ride out whatever small caps throw their way regardless of the technical or fundamental data.
  2. Those that are more position or trading oriented and have likely already taken some action to reduce their exposure. They are likely sitting on a higher than normal cash position or switched to an index with better relative strength.
  3. Those that are looking at this underperformance as small caps working off some overbought steam and are appearing more attractive from a value standpoint than large-cap alternatives.

No matter what category you fall into, analyzing the landscape and evaluating your options can be a fruitful exercise in disciplined portfolio management.

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