Small-Caps Look To Break Through Resistance

I’ve been writing a fair amount about small-cap stocks lately since they’ve underperformed large caps in 2014.

small-caps

The performance disparity is somewhat unusual given that small-caps tend to lead in a bull market. But as I wrote in mid-November, small-caps have likely trailed this year since they got ahead of themselves in 2013.

That year they rose by 36% as compared to a 26.4% rise in the S&P 500. That rally led the S&P 600 Small Cap Index to trade with a forward PE of over 19. That’s a little rich. In my opinion, this was the catalyst for the lackluster performance in 2014.

The case against small-caps gained followers when the Russell 2000 Small Cap Index completed a “death cross” formation in mid-September. This event occurs when the index’s 50-day moving average (DMA) crosses below its 200 DMA.

At that time I wrote not to fear the death cross, and that investors should actually view the event as a buying signal. That’s because 30 years of data show that investors would have made money buying into the death cross 69% of the time. And if they held small-caps for six months they would turn an average gain of 13.6%.

It’s been just over two months and the Russell is up nearly 7%. So far, so good.

Heading into the final stretch of 2015 the conversation around small-caps has changed. It’s not about death crosses and historical relative performance. It’s much more about the potential for the asset class to deliver a healthy gain to investors over the next year.

And I still think there is significant potential. We just need two things to happen.

By the way, when considering how to play small-caps as an asset class, I like to point investors to ETFs. And in particular, I like ETFs that track the S&P 600 Small Cap Index. You can find options through both Vanguard and iShares.

The S&P 600 has outperformed the Russell 2000 by 1.8% annually between 1994 and 2013. Over a 20-year period that outperformance leads to $17,654 more in capital gains. So there’s really no argument in my view.

Getting back to what we need to happen for small caps to bounce back in 2015, we need to see the S&P 600 break through resistance around 685. It is extremely close right now, so keep watching this level carefully.

Second, we need reaffirmation that analysts see earnings in the S&P 600 growing by 20% in 2015. This hasn’t happened yet, and I think that’s the final piece that we need.

The S&P 600 trades with a forward PE of 17.8 based on estimated earnings of $38.40 over the next four quarters. That’s just a little too high in my opinion for funds and other big buyers to aggressively buy small-caps.

We need better visibility to see that Q4 2014 earnings will come in at least as expected, than we can get a better handle on the potential for 2015 earnings to grow by 20%. At that point, we could see the S&P 600’s forward PE reset into the 16 range.

And to me that would give small-caps the lift they need to push through 685 and higher.

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