Wednesday, 2 October 2013

How Much Longer can Small-Caps Outperform?

I have been pleasantly surprised this year to see small-cap stocks outperforming their large-cap cousins in the UK, US, and Eurozone pretty much all year long. As a simple example, while the UK FTSE-100 benchmark index sits close to its 3-month lows, in contrast the FTSE Small-Cap index is only 2% off its all-time high!

Small-Caps around All-Time Highs!

If we look at three small-cap indices, the FTSE UK Small-Cap, the MSCI Europe Small-Cap and the S&P 600 Small-Cap, we can see in each case that small-caps are still very close to their all-time highs. 

UK Small-Caps 2% of all-time highs

MSCI Europe Small-Caps also within spitting distance of highs

Last but not least, US Small-Caps Breaking Higher
Note the last chart, where US small-caps are breaking out to a new all-time high despite the obvious question marks in the US about political gridlock in Washington. 

Economic Momentum Helping Domestic Stocks

One key indicator that is positive for domestic economic momentum in the US is the recently-released national ISM manufacturing survey: the reading for September clearly outperformed expectations with a solid rise to levels not seen since early 2011. 

US manufacturing showing strong positive momentum
This is equally true of the UK economy, where manufacturing is also seeing an accelerating rate of expansion:

UK manufacturing also returning to early 2011 levels of growth
So, this is all very well, but it could well be argued that this good macro news is already reflected in the current price of small-caps: more importantly, where next?

Seasonal Performance Suggests Continued Caution

Interestingly, looking at the case of Small-Caps, it would seem that the worst month of the year for performance historically has been September (which was actually decent for small-caps this year): 

September has been the worst month for small-caps

But I wouldn't assume from the chart above that the worst is past, now that we are into the month of October. After all, you need also to consider the following chart:

Small-Caps: Worst months have been August-October
So despite the strong upwards momentum of small-cap indices and the favourable macro following winds, I would not conclude that all will be plain sailing necessarily this month for small-caps. 

So what to do? Stay long small-caps, but watch carefully!

Let us not forget that, in the long-term, mid- and small-cap  stocks in the UK and US have tended to outperform the FTSE-100 and S&P 500 benchmark large-cap indices by quite a distance, albeit at the cost occasionally of higher investment risk at times of recession/crisis. 

One market indicator I like to keep a close eye on in the US at times like this is the cumulative breadth (advance-decline) indicator for US stocks (from Barrons) - so far, this looks fine, with the cumulative breadth line still advancing wekk-on-week. If this were to start to fall, then I would get worried about a potential correction...

US market breadth still up, giving comfort to small-caps

So remember that October can still be a terrible month for small-caps; stay invested in small-caps (as I am), but then watch the small-cap indices very carefully for any signs of impending market correction... 

My favourite UK small-caps for the moment: British Polythene (BPI), T. Clarke (CTO), Communisis (CMS), Inland Homes (INL), James Latham (LTHM) and Workspace Group (WKP). In France, I like Manitou (MTU) and Trigano (TRI). But as always when investing in single stocks, do your own research!

Hang in there,

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