Small Cap Stocks are Rallying

Small Cap Stock Investing

Right after the US presidential election, small cap stocks rallied and gained more than 16% between November and December. After this they seemed to stagnate with the Russell 2000 Index lower in August to where it was in December last year.

This seems to have finally corrected itself as the index has finally caught up with a number of other indexes around the globe. The Russell 2000 is now up by more than 10% since the beginning of the year. You can see this in the graph below.

The graph shows that highs tend to cluster in particular places. It is indeed clear that 2013 was a year of breakout but there were a number of other highs prior to this. Of course assets cant rise all the time but the fact that these types of stocks are rising points to the fact that investors are looking for more risky stocks to invest in.

More Risky?

Of course, they are indeed risky and volatile. You may not be aware that small cap stocks were actually in a bear market between late 2016 and early 2017. The Russel index fell by 27% from the highs to the lows. We also know that small cap stocks have much larger drawdowns.

Some investors are of the view that small cap stocks can give an indication of potential falls in large caps that will eventually come. This is however not true as we can see situations where the small cap stocks will fall by double digits when the large caps will fall by only single digits. These small cap stocks are about 20% greater in volatility than large caps.

Of course the volatility and correlation will be working both ways. For example, over the last month we have seen the Russel index up above 8% when the large cap index has been rather muted. Hence, the correlation between the two indexes is not always easy to identify.

If one was to use a technical and economic model to map the returns of the small caps over the past 90 years going back to the 1920s, we can see that the small cap stocks have indeed outperformed the large cap types. Yet, with the increase in smart Beta funds around the world and efficient tracking ETFs many people are asking whether this can be maintained.

Business Distress and Small Caps

However, whether there will indeed be great returns for those investors over the near term when they invest in these small cap stocks, what is indeed clear is that they provide an important piece of diversification from other market movements. You can see in the below graph the diversification benefits from the small cap stocks.

Clearly, one of the largest problem with these small cap stocks is the fact that they tend to go into administration a lot more frequently than other companies. They also tend to change their business models much more frequently than other types of businesses.

For example, a company called AQR Capital management shows that the returns from these small cap stocks can be increased by looking through the historical data and removing all of the “junk” variables. This shows that absent any of that business distress situations, small cap stocks can good fundamental investments.

Conclusion

What this does indeed show is that investors who are holding a portfolio of large blue chip stocks in companies on the S&P 500 should consider their diversified portfolio. They should also invest in other companies that form the component of the Russell 2000 small cap stock index.

Volatility is indeed a reality but these investors should also consider the impacts of diversification and the lack of correlation with the larger indexes. Moreover, as we have shown, when the investors remove the impact of business distress from this index then the downside risk is greatly reduced and the investors are likely to see greater returns.

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