On the whole, U.S. stocks are severely overvalued. Even the market itself knows it. The iShares Russell 2000 (IWM):S&P 500 SPDR Trust (SPY) price ratio (IWM:SPY) demonstrates the extraordinary weakness of small company shares as they relate to large companies. Moreover, small-cap stocks typically lead the way when investors believe in the strength of an economic expansion. Yet U.S. small-cap stocks via IWM have registered negative returns for 2014. That’s a far cry from the celebratory atmosphere surrounding the mighty S&P 500.
It’s not just small caps in the Russell 2000 that are struggling. The smallest corporations in the Russell Microcap Index have been losing steam as well. The iShares Russell Microcap Fund (IWC) is negative year-to-date and the current price sits below a long-term 200-day trendline.
So why are small caps and smaller caps having such a difficult time? First and foremost, the stock market boom has largely tracked the increase in the money supply since 2009. The 10%-20% corrections that occurred between 2009-2011 did so when the Fed briefly exited the dollar creation/rate manipulation game. With the Fed ending its third iteration of quantitative easing (QE3) near the end of 2014, smaller companies look particularly vulnerable; the U.S. economy has yet to show that it can sustain itself without the Fed’s unconventional bond purchases or “bond twists.”
Second, smaller companies that increased their leverage by borrowing at ultra-low rates to finance share acquisition are more susceptible to balance sheet fears than larger corporations. Indeed, the data already indicate that corporations have been slowing the pace at which they buy back their own stock. Now add valuation concerns to the mix. It is unlikely that executives at any company would brazenly continue to repurchase shares at exorbitant prices. As the artificial demand for shares of small companies dissipates, the price depreciation could get ugly.
Finally, Janet Yellen’s Fed may not be able to kill small-cap speculation with words alone. Yet the specific “calling out” of smaller companies in the biotech and social media space has shown signs of spreading across all small-cap company stock ETFs. If it is true that bull markets infrequently last beyond five years – and if Fed quantitative easing (QE3) does run its course this year – the least one should do is play the tuba rather than the flute. Small-cap fans can always reevaluate the landscape, particularly if they are treated to QE4 and QE5.