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The Single Best Predictor of Equity Returns in 2014?

  • Markets
  • Michael Gayed

Market Cap. There continues to be an uncanny relationship between a company’s market capitalization and year-to-date returns. The largest 500 stocks in the Russell 3000 are up an average of 8.5% this year, while the smallest 500 are down an average of -6.1%.

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From the beginning of July, when the small cap Russell 2000 Index peaked, the differential has been stark, with the top 500 stocks only marginally lower while the bottom 500 are down over -5%.

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What is driving this incredibly strong relationship between market cap and return?

It can be explained in part by a simple reversion to the mean as last year the smallest stocks (microcaps) widely outpaced the S&P 500 and we are seeing a complete reversal thus far in 2014.

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But there is more to the story here. As I have been writing about since January, small caps had been outpacing large caps for over fifteen years. This incredible run has left their shares extremely stretched on both an absolute and relative valuation basis.

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One could quite easily make the argument that small cap valuations are at/near their most extreme in history (See: “US Small Cap Rally Sends Valuation 26% Above 1990’s”). Indeed, one of the smartest minds in the investment business, Jeremy Grantham of GMO (with over $100 billion in AUM) is projecting U.S. small caps to have a negative real and absolute return over the next seven years.

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This suggests that the underperformance in small caps this year may not be a short-term phenomenon and could very well continue for some time. It also suggests that small-cap effect that many have become accustomed to may be absent for a while, at least until valuations are normalized.

What does this mean for the broad markets? For now, market participants remain highly bullish and are largely ignoring the small cap weakness, focusing instead on the all-time highs in the Dow (DIA) and S&P 500 (SPY).

Many of these participants are pointing to March and April of this year when small declined in consecutive months while the large cap indices continued higher as a template for what will happen next.

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While this is certainly possible, I would caution investors against assuming this is high probability and a normal market relationship. It is not. As I wrote back then, this was the first time in history that such a consistently wide divergence had occurred.

Also, if you believe that small caps are declining because of valuation concerns, wouldn’t it stand to reason that investors will soon become concerned with large cap valuations? After all, while large caps are cheaper on a relative basis, they are anything but cheap on an absolute basis, as evidenced by the negative real returns expected by Grantham over the next seven years.

I would also note that despite the daily headlines about all-time highs, the most defensive area of the market, long duration Treasuries (TLT), continues to widely outperform. We are also seeing other signs of classic late cycle behavior, as I wrote about recently in showing the troubling similarities to July 2007.

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Overall, the rotation out of small and micro caps should not be ignored by market participants. It is a clear sign of defensive behavior and is likely to have ramifications on investor returns not only in the near-term but for years to come.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie Bilello on twitter here.

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