2014 has been an unusual year for small caps, as this size segment rarely gains only single digits. Looking at data from the CRSP, we see that returns have been positive but less than 10% only 10 times before. 2007 being the most recent year with returns at 0.02%. After such a slow year, small caps might be expected to roar back and post strong gains the following year. Unfortunately, historic data shows that this is not the case, with the subsequent one-year return of -3.0% and the median even worse at -5.9%.
For valuation, we first look at absolute valuations. Small caps look less expensive but that does not mean they are cheap. Due to the weaker absolute performance, the forward P/E for the Russell 2000 has dropped slightly. Looking at graph 1, we see that small caps currently trade at 18.3x forward earnings, lower than the 19.5x at the start of the year. However, historically it is still high.
Secondly, we can look at relative valuations (graph 2). Due to the underperformance of small caps versus big caps, relative valuations of small caps have fallen as well. However, it still looks rather expensive.
If volatility moves up in 2015, which is likely since the “Fed Put” is no longer in place, the VIX index would move higher. When this occurs, small caps tend to deliver weaker absolute and relative performance. In graph 3 you can see the year-over-year change in the VIX index and the performance of the Russell 2000. This makes sense since riskier assets should struggle when markets become more uncertain.
In short, the relative bad performance of 2014 for small caps will not immediately result in a rebound this year. Contrarily, 2015 can possibly become a very tough year for small caps.
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Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.