After strong performance in 2013, small cap stocks have been pummeled this year by mixed economic data and high volatility. I invested in some small caps that were in the red zone for a while during the year suffering from the same woes, but I held on to them since I believed in the long term story. But in the last month things seem to be looking up for them as economic conditions and market data provide a ray of hope for these battered stocks.
Changing Trends: 2014 has been a difficult year for small cap stocks, but the trend appears to be changing. As an example I observed the price trends in the SPDR S&P 500 ETF Trust ETF (NYSEARCA:SPY) (for large cap stocks) compared with two ETFs for small cap equities, namely, the SPDR S&P 600 Small Cap ETF (NYSEARCA:SLY) and the iShares Russell 2000 ETF (NYSEARCA:IWM). Since these are fairly broad ranged in terms of sectors and companies, I decided to use these for comparison purposes.
While the price performance for one year ended November 3rd 2014, showed modest results (in the 5 to 6% range) for the SLY and IWM funds compared with the over 14% price return on the large cap SPY fund, the story has been changing as we move to more recent data. For the month of October 2014 the price performance of the same indices has been changing with over 8% price returns for the small cap funds versus about 4% for the SPY. This could be an early sign of growing investor confidence in the small cap sector.
Another interesting detail in the price data for these ETFs emerged around October 15th when the stock markets experienced what some are referring to as the long anticipated “market correction.” Typically small companies and stocks are expected to be more susceptible to market volatility. But on this particular occasion SLY and IWM did not exhibit higher volatility as compared to their large cap counterpart.
Global Dynamics: One reason that I can see for a more positive outlook on the future of small caps is the divergence in economic performance of the United States compared with the rest of the world. The domestic U.S. economy has been showing overall signs of firming as seen in improving GDP growth and labor market figures. But headwinds in Europe and Asia continue to sour the global economic picture. Given these dynamics the strengthening of the dollar is likely to be more than a short blip. In such a case there is greater downside to earnings of large companies with more overseas exposure as compared with many small caps that make most of their money domestically.
Also as long as the U.S. economy continues to grow there should be renewed demand for the goods and services in some of the lower performing sectors of the past year, such as, industrial goods. Investment in infrastructure (domestic and global) could help the sales of companies in this sector. Some small caps I am watching in this sector including Ceco Environmental Corp (NASDAQ:CECE), U.S. Ecology (NASDAQ:ECOL) and Allied Motion Technologies (NASDAQ:AMOT).
Conclusion: Overall I think that there may be hidden gems that may have been overlooked by investors due to the overall lackluster performance of the small cap stocks as a group and in the near future we may begin to see these stocks generate a greater return than their large cap counterparts.
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