Market Changes Beneath the Surface

Last week, the S&P 500 Index reached yet another all-time high. The S&P 500 has moved about 9% higher year-to-date and is up roughly 17% over the last 12 months. The Nasdaq has outperformed the S&P 500 over both periods. It is up about 10% year-to-date and 22% over the last year. In contrast, the Russell 2000 is about flat year to date; it has moved about 8% higher over the last year.

However, if we dig deeper, we see a different picture. Roughly 47% of stocks in the NASDAQ Composite Index are at least 20% below their peak levels of the last 12 months. (The NASDAQ is a cap-weighted index, so the performance of its largest members strongly outweighs that of its smallest components.) The picture for the Russell 2000 Index (the 2000 smallest stocks in the Russell 3000 Index) is similar to that of the NASDAQ, as more than 40% of its stocks have fallen at least 20% over the last year.  The picture is sharply different for the S&P 500. The Index has closed at a new high 34 times in 2014 and less than 6% of its companies are in bear market territory (down at least 20%).

Divergence in Small- and Large-Cap Stock Performance

The divergence in the performance of small and large-cap stocks can be indicative of a couple of factors. First, investors’ appetite for risk is likely narrowing as the Federal Reserve continues to reduce its efforts to stimulate the economy (on September 17, the Fed reduced its quantitative easing program by another $10 billion). Second, the current bull market has been going on for more than five years, raising the possibility that a pullback of some type may be in order.

Typically, smaller stocks outperform their larger brethren in the first part of the market cycle, which often follows a recession. Smaller stocks are weaker performers during a downturn, so it follows that they typically outperform large stocks coming out of a downturn. As an economic expansion matures, growth slows. This leads investors to favor large-cap stocks for their dividends and stability. In the current low-interest-rate environment, the attractiveness of income-producing stocks is even higher, as there are comparatively few places for investors to park their cash and generate income.

We do not mean to say that this data means a bear market is imminent. There are some indications that we could be in the latter stages of the bull market, but we also know that trying to forecast the market’s short-term direction is folly. While many are paid to forecast the market’s performance, there are not any pundits we are aware of with a consistent track record.

BWFA Investment Approach

At BWFA, we maintain our positive long-term market outlook. In our view, the recent underperformance of smaller stocks represents opportunity. As a result, we are looking for attractively valued, well-managed small-cap stocks that we believe have been punished unfairly in the current market. It is possible that we will be early in identifying such companies. However, over the long term, it is usually better to buy a little early rather than be too late and miss a significant portion of a security’s gains.