Small Cap Stocks Bubble Despite Weak GDP and Modest Earnings
by The Curmudgeon
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.
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.
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?
Sperandeo ("the man for all markets") certainly thinks so! He wrote the Curmudgeon in an email:
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:
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."
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:
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
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.....................
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.