Lagging Small-Caps Are a Bad Sign for Investors

The stock market rally of 2014 is not uniform. Turns out that not all stocks are created equal. Small–cap stocks are negative this year, at odds with their historical tendency to do well in an economic expansion. That sounds a cautionary note for investors.

Most people think of the market as the Standard and Poor’s 500, which is the most tracked index in the world. The S&P 500, which represents only large capitalization stocks, is up 6.52% total return (price increases plus dividends) thus far this year, despite recent days’ wild rides. Meanwhile, the Russell 2000, the standard small-cap index, is down 4.78% for 2014.

Oddly, the Russell index (its average stock has a $1.8 billion market value) surged 37% last year, outpacing the S&P ($36.8 billion) by seven percentage points.

Why are small-caps suffering the most lately? A major culprit may be the prospect of rising interest rates. The Federal Reserve this month is ending its bond-buying stimulus program, designed to keep long maturity bonds’ yields low, and many observers believe the Fed will hike short-term rates in 2015. Smaller companies have more difficulty raising capital than do large ones, and higher borrowing costs would hinder small-caps more.

Recently, you heard buzz about new market highs, making it sound like everyone has joined the party. But that isn’t the entire story. The invitation list for the party seems to be shrinking with each new market rebound. That’s a significant concern for those of us with a vested interest in the longevity and security of the markets.

The S&P 500 is an unmanaged index of U.S.-based companies originally created to track the strength of various economic sectors. S&P 500 companies must be U.S. based, meaning some very large companies in our country, like Toyota (TM), are not included.

Market capitalization has nothing to do with the size of the company, number of employees or business model. Market cap is one share of stock at the current price multiplied by all the outstanding shares of that particular company. Some companies like Microsoft (MSFT) and General Electric (GE) have billions of shares outstanding while other companies have millions.

Market cap can vary dramatically, hence the words large, mid- and small-cap in your retirement accounts. Today, the top 10 companies by market capitalization control more than 20% of the index’s daily movement, similar to how some party guests make more noise than others.

The current party clearly consists of the largest of large caps. The 100 largest companies only have 1% of the components in bear market territory – bear market refers to those companies that are more than 20% below their latest high price.

Contrast that with the Russell 2000 with more than 40% of the holdings in bear market territory. In fact, more than 47% of the companies listed on the tech-heavy Nasdaq find themselves in bear market status.

Is the market overpriced and poised for a loud popping sound like the tech wreck of 2000? That’s impossible to determine with absolute assurance. Our economy is stronger than most people are willing to admit or understand. Both equity and bond markets are creating confusion for the greatest financial traders.

The only certainty right now is that as fun as the party’s new market highs may be to talk about, not everyone is participating. Make sure you know what you own in your portfolios.

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Written by Joseph “Big Joe” Clark, CFP, is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He teaches financial planning at Purdue University and is the host of Consider This with Big Joe Clark, found on WQME and iTunes. He is a Registered Principal offering Securities and Registered Investment Advisory Services through World Equity Group, Inc, member FINRA/SIPC. Big Joe can be reached at bigjoe@yourlifeafterwork.com, or (765) 640-1524. Follow him on Twitter at @Big Joe Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.

Securities offered through and by World Equity Group Inc. Member FINRA/SIPC. Advisory services can be offered by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.

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