Why small-cap stocks have been lagging behind in 2014

For example, at least historically, small cap valuations have been more sensitive to changes in monetary conditions than their large-cap counterparts, and this was evident last week. While U.S. large caps, as measured by the S&P 500 Index, were never down more than 5% from their highs, U.S. small caps entered correction territory (defined as a decline of 10% or more), as measured by the Russell 2000 Index.

Why small-cap stocks have been lagging behind in 2014

Market Realist – The graph above shows the total returns from the S&P 500 (SPY)(IVV) and the S&P 600 for small-cap stocks. Small-cap stocks have been falling steadily in 2014. This is primarily because the Russell 2000 (IWM) entered 2014 highly overvalued.

The Russell 2000 rose 37% last year compared to the 30% gain by the S&P 500 (SPY). In March 2014, the Russell 2000 (IWM) had a price-to-earnings multiple of 49x, while the S&P 500 had a price-to-earnings multiple of 17.2x. Some small caps were extremely overvalued. LogMeIn (LOGM) and Athenahealth Inc. (ATHN) were among nine companies in the Russell 2000 Index with a price-to-earnings ratio above 1,000x, as estimated by Bloomberg.

As the Federal Reserve intends to conclude its bond buying (TLT) program in October and raise rates next year, markets are expected to experience an upward trajectory in volatility levels (VXX). An increase in volatility affects U.S. small caps more than large-cap equities.

A further fall might be in the cards for overvalued segments like small-cap stocks.

Read on to the next part of this series to see why emerging markets tend to be vulnerable to changing monetary conditions.