Small-Cap Breakdown?

Small- and micro-cap stocks have had a good run lately, but the bullish momentum is now fading. In the long run, finance theory tells us that these corners of the equity market will generate a risk premium over and above the broad stock-market benchmarks. In the short run, however, gravity can and does intrude on the party if performance gets ahead of itself.

Consider the recent red-hot performance for the smallest of the small in the US equity space—microcaps, based on iShares Micro-Cap ETF (IWC). A month or so ago, IWC was running strong compared to large caps. Today, there are signs that the rally has become overextended: IWC and its small-cap cousin, iShares Russell 2000 (IWM), have recently slipped below their 50-day moving averages and are hovering just slightly above their 200-day averages. By comparison, our ETF proxies for mid-, large- and mega-cap stocks are still trading at premiums over their 50- and 200-day averages.

tab2.06may2014

It’s not terribly surprising to see micro- and small-caps correcting. Trees don’t grow to the sky and so the hefty return premiums we’ve seen in these corners over the broad market were due for a reversal. For the moment, however, the correction has only trimmed the sails rather than cut into the hull. As the chart below reminds, micro caps are still outperforming large caps over the past 250 trading days. But the descent from recent highs has been steep and swift. It’s anyone’s guess if the deterioration will persist, but if it does it could signal problems for the broader market.

chart1.06may2014

Microcaps have been known to be the canary in the coalmine, so to speak. These companies tend to be high-risk stocks, which makes them unusually sensitive to changing hazards on the macro front. The good news is that the economic trend is looking stronger these days after a harsh winter. A spring rebound appears to be underway for the US economy, or so the latest numbers imply. The weak spot is housing, although it’s not yet obvious that this is something darker than a rough patch.

Nonetheless, keep your eye on the canaries in the equity market. It’s unclear if we’re seeing a “normal” correction vs. an early sign of trouble that will spread. For now, it’s still reasonable to assume that it’s just a pause that refreshes.

3 thoughts on “Small-Cap Breakdown?

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