Runts MIA at Stock-Market Party as Corks Pop for S&P 500 Record

Jul 24, 2014 1:23 pm ET

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July 24 (Bloomberg) -- The great amount of worry we devote to the smallest and most vulnerable members of our species is a natural and endearing element of human nature.

The shopping list for protective parents these days is long -- the helmets, the elbow pads, the mouth guards, the car seats. We’d bubble wrap them on the first day of kindergarten if we could, and maybe one day we will if Target Corp. starts selling a cute bubble outfit.

So what then of the smaller members of the stock market? Is it time to start worrying that they’re missing from the party as the big companies celebrate the return to a record for their benchmark?

The Russell 2000 Index, whose average $1 billion market value is 1/38th the average company in the Standard & Poor’s 500 Index, last set a record on March 4. It made a good run at it earlier this month but stopped about half a point short of the high and is now almost 4 percent below it.

The total market value of the Russell 2000 is a little more than $2 trillion, not much bigger than the five largest companies in the S&P 500. Still many among us can’t help but worry, concerned that the party won’t be “confirmed” until the entire market is on the dance floor.

Relative Weakness

“The relative weakness remains one of our areas of concern but our thought is that some more time needs to be given before any definitive conclusion can be made, largely because small-cap companies generally report later than larger caps,” Michael Shaoul and colleagues at Marketfield Asset Management wrote in a note today.

About 18 percent of the Russell 2000 has released results so far in the reporting season, compared with 41 percent of the S&P 500, according to data compiled by Bloomberg. Earnings growth for the smaller firms has been 12 percent on an almost 8 percent increase in sales. S&P 500 earnings have increased 11 percent on sales growth of 4.9 percent.

There are other reasons to worry about the runts, however. In a yield-hungry world, dividend payments are at multiyear lows for both large and small companies. Yet the Russell 2000’s yield, at 1.28 percent, is the least competitive to the S&P 500 than it has been in almost four years.

And that brings us to the big elephant in the room: the notion that interest rates will rise eventually, maybe, probably, possibly, potentially, one day, maybe?

Smallcaps actually have performed pretty well following the first Federal Reserve rate increase in past cycles, with an average gain of 7.7 percent in the following 12 months, according to research from Pavilion Global Markets. Yet this tightening cycle will be unique because it is not beginning until five years after the end of a recession and at a time when small-cap valuations are very expensive compared with larger stocks, according to Pavilion’s July 18 note that predicts further underperformance.

In other words, maybe the stock-market’s party isn’t over. It’s just time for the grownups to take over the dance floor.