By David Sterman
Investors in small-cap stocks have rarely had it this good.
The Russell 2000, which stood below 400 in early 2009, is quickly approaching the 1,200 mark. It's as though two decades worth of gains have been packed into just five years.
Yet as we turn the page and head into 2014, it's crucial that you understand how a changing economy will influence this trend. For a host of factors, small caps are likely poised to underperform their large-cap peers.
In August, I explained
why investors should shift assets into larger companies, and since then, the reasons for owning big-cap companies have only strengthened.
First, the market has moved even higher since last August, with the Russell 2000 up another 9% and the S&P 500 Index rising another 8%. If investors are looking to lock in profits in 2014, then larger companies, especially those with robust buyback and dividend policies, are likely to hold their own better than small caps.
Much more importantly, it's the recent economic releases that point to a better backdrop for larger-cap companies.
Post-Recession Performance (prior to 2009)
As I noted back in 2010, small caps do well as the U.S. economy edges out of recession because these smaller companies have more direct exposure to the U.S. economy. Indeed most of these firms haven't felt the pain of a still-weak European economy. Bigger firms, in contrast, have been weighed down by slower growth at their foreign sales units. In places like Europe, that's becoming less of a drag.
Also, large firms are much more attuned to higher capital spending. According to Goldman Sachs, fixed investments by businesses, also known as capital spending, likely grew just 2.5% in 2013. Yet Goldman thinks that will figure will surge to 6.8% in both 2014 and 2015, and 5.5% in 2016. Capital goods manufacturers such as GE
) and United Technologies
) stand to be clear beneficiaries.
Of course, smaller companies would stand to benefit as they are key suppliers to these big firms. It's why small-cap industrials are likely to be one of the few pockets of strength among all small caps in 2014.
Why does Goldman suspect that capital spending is about to pick up? Because the numbers are already improving. Orders for durable goods (aircraft, machinery, appliances, etc.) rose 3.5% in November, the largest increase in nearly a year.
The robust durable goods figure has led economists to suspect that fourth-quarter GDP growth may approach or even exceed 3%. Recall that third-quarter GDP growth figures were pumped up by inventory building, which typically creates a hangover in supply chains in the subsequent quarter. Back-to-back quarters of GDP growth in excess of 3% would be undeniably impressive. It's happened only once since the Great Recession ended (the fourth quarter of 2011 and the first quarter of 2012).
I still think that mega-cap exchange-traded funds (ETFs) are a great way to pay this theme. They include the iShares S&P 100 Index
), the Vanguard Mega Cap Growth Index ETF
), and the Vanguard Mega Cap Value Index ETF
Now, here's where things get tricky. I am in the camp that expects stock market gains will be much more muted than in recent years. My colleague Michael J. Carr recently cited technical concerns for the market
, and indeed a number of other technical indicators beyond what Michael cites also suggest overbought conditions.
But on a fundamental basis, I am growing a lot less cautious. The fact that the economy has managed to strengthen, even after the government shutdown and sequester issues, is undeniably impressive. Moreover, stocks are not expensive, especially in the context of very low interest rates.
Risks to consider: The economy is getting better, but the market's rally has anticipated much of that eventual improvement. So it's unwise to expect major gains in 2014. Also, many investors may look to lock in profits in early 2014, avoiding the tax man's 2013 bite.
Action to take: Over the course of this year, I have been eagerly awaiting a market pullback to reveal fresh buying opportunities. Yet that pullback never came. And so many stocks not trade for twice or even three times as much as they did a few years ago. As a result, few bargains exist. But a wide range of industrial stocks appear reasonably valued in the context of 2015 and 2016 results.
The firming economy increases the likelihood that these companies will generate a large cyclical upturn in profits.
My preferred strategy: Exercise patience as we head into the fourth-quarter earnings season, and keep an eye out for companies that issue tepid near-term guidance but are still deeply leveraged to a longer-term cyclical upturn. I'll be keeping an eye out for such bargains as they (hopefully) emerge in coming weeks.
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