The fed tapers: Will small caps weaken relative to large caps?

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Risk factor #2: Small caps outperform large caps in the long run

As the below graph indicates, over time, broad market indices such as the Russell 2000 (which hold numerous smaller companies) outperform narrower indices, such as the Dow Jones 30, with very large companies. As we noted in the prior article of this series, this is the small company effect. Investing in more smaller companies relative to larger companies should raise your average return over time, though smaller companies can also go down more than large companies during bear markets. A bear market due to rising rates is always a risk, though one that can be mitigated through strategic investing. This article considers the differences in the three main indices noted in the below graph, and the implications for equity investors concerned with the possibility of higher interest rates in the future.

Broad Market Indices Russell 2000 SP 500 Dow

For an overview on these risk factors, please see Key strategy: 4 key risk factors as the Fed tapers.

Why is this important?

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Determining which index, with its specific risk factors, is the most appropriate for an investor depends upon the investor’s appetite for risk. In general, the smaller the company, the greater the volatility of the company’s stock price. That means more risk. Plus, the more aggressively a company is priced—such as a high prices technology stock with small earnings—the more volatile the stock price of that company. In contrast, a company with a low valuation, known as a “value stock,” may have a low stock price (a low price-to-earnings multiple), as earnings are consistently modest and grow quite slowly. We’ll consider the trade-offs of anticipated growth and upside potential versus the relatively cheap pricing associated with value stocks.

 Why the Russell 2000 outperforms narrower indices

“Market breadth” refers to the diversity of equity holdings. In the above graph, the Russell 2000 (2,000 companies included) clearly has the greatest breadth, followed by the S&P 500 with 500 major companies, then the 30 mega cap component index of the Dow.

More price volatility in small companies

The broadest market index, the Russell 2000, outperforms other indices. This is because the Russell 2000 holds many smaller companies in its index relative to the S&P 500—and certainly relative to the Dow, which holds entirely the biggest companies from various industry sectors in its index. These smaller companies tend to have more risk, and they exhibit greater price volatility as a result. As noted in the first article in this series—the Capital Asset Pricing Model, or CAPM, says that the more risk you take, the more you stand to make or lose in terms of equity returns. In other words, your portfolio returns are a function of risk, and there are no exceptions to this rule, or as the academics say, “no free lunch.” Therefore, should the market experience a interest rate shock, it’s possible that small caps could underperform their safer lower-returning large cap peers, and the trend in the above graph could reverse to some degree.

Diversification is key

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As we see above, the inclusion of exposure to smaller companies in your investment exposure can enhance the return of the portfolio—the Russell 2000 index reflects this tendency. On the other hand, during bad economic times, smaller companies can underperform larger global blue chip companies. The stock price of smaller companies tends to exhibit greater sensitivity to business cycles, as their profit margins may shrink or rise more dramatically than the margins of larger companies.

Higher cost of capital: Fewer advantageous financing opportunities for smaller companies

Similarly, smaller companies may face more expensive financing alternatives in the form of debt (bonds, bank loans) and equity issuance. In other words, these companies have a higher “cost of capital” relative to larger companies, as smaller companies typically involve a higher level of investment risk. This means smaller companies tend to outperform larger companies during a period of anticipated economic growth, though they underperform larger companies in a period of economic decline.

To see how value versus growth could be affected by the end of the Fed’s bond purchase program, please see the next article in this series.

Equity outlook: Constructive macro view

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Despite problems in Ukraine and China, and despite the modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment the improvement in the current economic recovery. For investors who see a virtuous cycle of employment, consumption and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).

Equity outlook: Cautious macro view

Given the China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), the State Street Global Advisors S&P 500 SPDR (SPY), the Dow Jones SPDRs (DIA), and the iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD), such as Walmart (WMT).

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