Small Cap Stocks Bubble Despite Weak GDP and Modest Earnings

by The Curmudgeon

Introduction:

For several weeks, the CURMUDGEON has wondered why the Russell 2000 index, global small cap stocks and many small cap equity mutual funds have hugely outperformed other stock indices and is totally inconsistent with very slow growth in corporate earnings and GDP.

The Russell 2000 index is up 27% YTD, while the MSCI World Small Caps index has climbed almost 22%, touching a record high last week. Selected small cap equity funds have done even better. Compare that to the Dow Jones Industrials and the blue-chip World Stock Index which each gained about 16% so far in 2013. Yet these huge small cap gains seem totally disconnected with the declining growth in corporate profits and the sub 2% growth in U.S. GDP.

Weight of the Evidence:

In the chart below, we see that the Russell 2000 is up 27% YTD, while the Dow and S&P are up considerably less in 2013. Equally important: the Russell 2K is down only slightly (and much less than the larger cap weighted indices) since Bernanke's "no taper" announcement on September 18th.

Table 1. lists 18 small cap mutual funds sporting YTD gains of 40% or more, with Lord Abbett Micro Cap Growth Institutional shares up over 61% YTD! How is that possible we ask (see below for explanations, bullish and bearish points of view)?

Table 1. U.S. Small Cap Stock Mutual funds up >= 40% YTD

Source: Morningstar Data Base as of Sept 23, 2013

Small Cap Growth funds:

· Adams Harkness Small Cap Growth ASCGX 43.99

· Buffalo Emerging Opportunities BUFOX 46.69

· Emerald Growth Institutional FGROX 40.51

· Essex Small/Micro Cap Growth Investor MBRSX 39.79

· Emerald Growth Investor FFGRX 40.13

· Franklin Small Cap Growth A FSGRX 40.64

· Ivy Micro Cap Growth Y IGWYX 42.71

· Lord Abbett Developing Growth F LADFX 48.24

· Lord Abbett Micro Cap Growth I LMIYX 61.25

· Managers Micro-Cap Institutional MIMFX 41.53

· Morgan Stanley Inst Small Co Gr I MSSGX 43.49

· Oberweis Emerging Growth OBEGX 40.19

· Oberweis Micro-Cap OBMCX 45.15

· RS Small Cap Equity Y RSCYX 39.78

· RS Small Cap Equity A GPSCX 39.99

· William Blair Small Cap Growth N WBSNX 42.40

· Wells Fargo Advantage Emerging Gr Instl WEMIX 41.53

Small Cap Value fund:

· Bridgeway Ultra-Small Company BRUSX 5.95 41.36

Explanations for Small Cap Outperformance:

In a recent blog post George Leong attempted to explain the small cap stock outperformance:

"Some of the gains we have seen are staggering. The momentum in this market along with the easy money have fueled a massive appetite for assuming risk, which has pushed small-cap stocks higher, reaching record after record. While you can earn steady returns from blue chips and big-cap stocks, for the quicker money, you need to have small-cap stocks in your portfolio. These small-cap stocks are where you see double-digit revenue and earnings growth, unlike the muted growth you often see from much larger companies."

Mr. Leong added, "Of course, with the added risk-to-reward, you are also assuming more risk. The probability to the downside is higher and shifts are quicker with small-cap stocks."

But Peter Sidoti of small-cap research specialists Sidoti & Co. doesn’t think that last statement is necessarily true. In this weekend's Financial Times, he argues that the perception that smaller companies are riskier is a fallacy. “People confuse volatility with risk,” he says. “When you look historically, volatility is actually the friend of the investor. For the speculator it’s dangerous, but for the true investor it’s advantageous.”

Although small-caps have historically outperformed, their recent resilience is nonetheless eye-catching. Smaller companies often find it much harder to raise financing even when growth is buoyant, and are usually the most vulnerable when economic conditions worsen and banks rein in lending. But, aside from a brief spike at the nadir of the financial crisis, default rates have remained subdued, as per the low default rates on high yield bonds.

Do Corporate Profits Matter Anymore?

Yet the huge gains in stock prices have come as corporate profit growth has been sluggish at best. Investor’s Business Daily reports: "Top-line growth will remain sluggish, but revenue is expected to rise 3.1%, up from Q2's 2.2%. Corporations are benefiting from easy comparisons. Q3 2012 profits rose just 0.1% and revenue fell 0.8%."

The Bullish Case for Small Caps:

The question now is whether the outperformance of small-caps can continue, or whether prices are becoming frothy. Many investors tend to jump into small-caps at the tail-end of a bull market, when prices of bigger companies seem too high.

For now, investors and analysts remain bullish, and point to still-reasonable valuation metrics. Barclays predicts the Russell 2000 index of smaller US companies will rise a further 4 to 6 per cent over the next twelve months – and possibly more if the economy stays on track.

“If you believe in an economic recovery, small-caps will lead the market,” says Vadim Zlotnikov, chief market strategist at AllianceBernstein. “Profit margins for large-caps are a lot more extended than those for small-caps.”

A Bearish Scenario: Are Small Caps in a Bubble?

Victor Sperandeo ("the man for all markets") certainly thinks so! He wrote the Curmudgeon in an email:

"Your charts showing Russell 2000 price appreciation vs. the decline in earnings growth are clearly a textbook case of a bubble. There are no fundamentals associated with the appreciation in small cap stocks. It is purely the Fed printing money and the widespread belief or impression that they will always print more money if the economy stays weak (which is very likely due to Obama's fiscal policy). Therefore, the conclusion for many is to own stocks. The end game will not be pretty. It will be a horror situation for all but the shorts sometime in the future....."

On a September 26th call with investment advisors, Double Line's Jeffrey Gundlach was very skeptical of lofty stock prices. He said, "The public has an eerie belief that the (U.S.) equity market can only go higher and there is no downside risk. That's wrong, just as it was wrong to think that long term interest rates can never go up."

Jason Zweig wrote an interesting piece about bubbles in this weekend's WSJ:

"Those with the worst tendency to “ride the bubble”—buying more enthusiastically as prices soared away from fundamental value—paid particularly close attention to other traders’ actions. “People seem to be buying,” Prof. Camerer says, “because they think they can sell to somebody else who isn’t able to control himself as well as they can or isn’t as prescient as they are.”

In other words, as prices rise and you intensify your search for that “greater fool” you can sell to, you may get distracted from noticing that the greatest fool of all is you."

Closing Comment:

Thanks to Victor Sperandeo for sending this along.......

In the early 1990's, George Soros gave a speech before the Committee for Monetary Research and Education and was quoted by John Liscio (former Barron’s reporter) as follows:

"Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited."

Most agree that bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears. Such a drop is known as a crash or a busted bubble. Assuming small caps are indeed in a bubble, the CURMUDGEON wonders how many "investors" and money managers will be able to "step off" and sell their long stock positions or mutual funds before the false premise is recognized and the bubble pops.

Till next time.....................

The Curmudgeon
ajwdct@sbumail.com

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.