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Small-cap stocks look to be leading the market higher and valuations look great.
Three weeks ago I wrote that I saw as much as 18% to 22% upside in small-cap stocks.
The asset class has been a relative dog so far in 2014, falling by 3% year-to-date as compared to a 6% rise in the S&P 500. But as I wrote in early October, “This dynamic isn’t likely to last much longer. When the reversal comes, small caps are going to lead the market higher.”
That reversal appears to be happening right now. Even though October has been a volatile month, small caps have actually done quite well, rising 1.7% as compared to a 0.4% decline for the S&P 500.
As the chart below shows, small-cap stocks haven’t been any more volatile than large caps. Two weeks ago, when the broad market was melting down and fell by 3%, small caps hung in there with similar losses. But two weeks ago, small caps rallied 2.5% while the broad market was flat. And last week, they rose 3.2%, almost keeping pace with the S&P’s 4% stock rally.
While I’m speculating here, this action suggests to me that investors took advantage of the crazy market to pick up values in small-cap shares (I know I did). After all, we’d typically expect the little guys to fall more than large caps. But they didn’t.
On a valuation basis, small-cap stocks look good to me. The S&P 600 Small Cap Index is now trading with a forward P/E of 16.2. This is not expensive. It traded up to a forward PE near 20 before this correction. And it’s only trading at a slight premium to the S&P 500’s forward PE of 14.6, even though small caps are likely to grow earnings far faster in 2015.
So how do you play it?
As I’ve written several times before, the easiest way to go is with an ETF that tracks the S&P 600 Small Cap index. Given the media’s affinity for the Russell 2000, you may wonder why I prefer the S&P 600.
Besides the S&P 600’s superior performance – since the beginning of 2010 it’s up 85% as compared to only 70% for the Russell 2000 – the spread of stocks in the S&P 600 better, the historical performance is better and the valuation is better. In other words, there is virtually no reason in my mind to buy into the Russell 2000 when looking for small-cap exposure.
If you go this route, buy iShares ETFs that track the S&P 600 (they have a value, core or growth option). Most online brokerages offer them with zero commissions so you can dollar-cost average in small dollar amounts.
Alternatively, go with a Vanguard ETF, which tracks the Center For Research in Security Prices (CRSP) U.S. Small Cap Index. These can also be bought without a commission from most online brokers, and the historical performance is similar to that of the iShares ETFs.
In either case, I see 10% return potential on this relatively conservative small-cap trade within the next two months and 20% or more within the next six months. That’s likely to be a superior return than the S&P 500 can offer over similar timeframes.
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