As of today, small caps are underperforming by nearly 10%. Given the rather large performance disparity it’s worth discussing whether or not small caps can make a comeback in 2015.
Over the long term small caps outperform. So their underperformance this year is a bit of an anomaly given the strength in the broader market. While the S&P 500 is up 12% in 2014, the S&P 600 Small Cap Index is up just 2.8%.
But if we look back over the past six years it’s a little easier to see why small caps fell behind this year.
Since the beginning of 2009 small caps are up 148%. That compares favorably to the 120% return for the S&P 500 index over the same time frame.
As the chart below shows, both indexes have performed extremely well in all but one year since 2009.
The only other year that small caps fell behind was in 2011, when they dropped 2.1% versus a 1.1% decline in the S&P 500. That differential is minimal compared to this year’s 10% disparity.
Why are small caps underperforming in 2014? The simple answer appears to be that they simply got ahead of themselves in 2013 – both in terms of relative performance and valuation.
After a 36% rally in 2013 small caps were trading at over 19 times forward earnings entering 2014. Even for rapid growth companies, that valuation is a bit steep.
The upside is that small cap valuations have become much more reasonable today, especially when we consider how fast they are expected to grow earnings in 2015.
Analysts expect earnings in the S&P 600 to grow by 21% to $39.21 in 2015. With the index trading at 670 right now, its forward PE sits at 17.
That valuation is slightly higher than that of the S&P 500, which trades at 15.7 times 2015 estimated earnings.
But I think the valuation premium is warranted. Small caps are expected to grow earnings by 21% versus just 10% for large caps. Both growth rates are extremely respectable, but clearly the more rapid growth of small caps warrants a higher valuation.
If earnings were to grow another 20% in 2016, and the S&P 600 maintained a similar valuation as it has today, the index would be trading at 800 one year from today. That would hand the index a 19.3% return over the next 12 months.
I think that is probably a greater return then we’ll actually see. But it shows the potential. Even a return of 10% to 15% would be very good, and is quite reasonable. Small caps just have to break through resistance in order to get the rally started. And that’s the main challenge at the moment.
As this two-year chart shows, the S&P 600 has been bumping up against resistance near 685 for nine months.
I think we will see small caps continue to hit resistance until the beginning of 2015, with a possible break-out in the first quarter. For that to happen we will need fourth-quarter earnings to come in strong. And we’ll also need a reaffirmation of 20% earnings growth in 2015.
Personally, I love small cap stocks. And I love holding them for the long term. To me, investors who pay attention to small cap stocks and want to outperform the market are starting in the right place – even if they are underperforming thus far in 2014.
Ultimately, the more rapid growth of small-cap earnings is going to lead to another period of outperformance. Since jumping in at that perfect moment is all but impossible, the best move is for investors to maintain (or build) exposure now, and hold on.
This article is brought to you courtesy of Tyler Laundon from Wyatt Investment Research.