Testing Wall Street's Small-Cap Apocalypse Theory

The Russell 2000 tracker tends to shine after one of these "performance gap" signals

Jul 29, 2019 at 6:47 AM
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The following is a reprint of the market commentary from the August 2019 edition of The Option Advisor, published on July 26. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.

If you've been following the stock market's rebound rally from its early June lows, then it's quite likely you've encountered, by now, a hand-wringing article or two about the dire implications of small-cap stock underperformance, even as the S&P 500 Index (SPX) has continued to new highs. The headlines have ranged from colorful ("This stock-market canary just keeled over," MarketWatch, July 12) to dire ("This group of stocks is flashing a warning sign -- ignore it at your 'peril,' says expert," CNBC, July 11) to matter-of-fact ("Small Company Shares Fall Behind in Sign of Economic Worry," The Wall Street Journal, July 22), interspersed with a few contrarian takes along the way.

And while it's not exactly a "contrarian take," per se, we'd like to point out that it seems a bit like cherry-picking to call out small-cap underperformance relative to the S&P. The graph below displays the daily relative performance of the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) versus a diverse trio of exchange-traded fund (ETF) benchmarks -- the U.S. small-cap focused iShares Russell 2000 ETF (NYSEARCA:IWM), the Hong Kong-, Korea-, and BRIC-heavy iShares MSCI Emerging Markets ETF (NYSEARCA:EEM), and the Japan- and Europe-exposed iShares MSCI EAFE ETF (NYSEARCA:EFA) -- and shows that the S&P is actually outperforming most of the world, give or take.

spy vs iwm eem efa 1h 2019

As of the close on July 10, 2019, IWM, EEM, and EFA were all three lagging the SPY's rolling six-month return by six percentage points or more. Looking at just one signal per six-month period, Schaeffer's Senior Quantitative Analyst Rocky White reports that there have been only six prior instances of this trio simultaneously underperforming SPY by such a wide margin. (And despite the ominous recurrence of the number six here, we'll refrain from the urge to describe these three ETFs as "horsemen" of any type.)

The table below displays the dates of prior signals and the six-month returns leading up to those performance gulfs. As you can see, all four exchange-traded funds (ETFs) have performed well since early January -- but the SPY has just absolutely crushed the competition.

iwm-eem-efa 6-month return signals

The first table below summarizes SPY returns after prior relative outperformance signals versus IWM, EEM, and EFA, while the second table shows the ETF's "anytime" returns since 2011. The short-term going after these signals has tended to be choppy, with SPY's average 3-month return of 0.87% lagging its usual return of 2.58% over this time frame.

However, the longer-term performance is encouraging. SPY returns were 100% positive at both the six-month and 12-month marks, with the average and median returns for each time frame comfortably exceeding the norm.

spy returns after efa-eem-iwm underperformance

And then there's IWM, which generally goes on to perform just as usual during the first three months after one of these signals -- before absolutely breaking out to the upside over the ensuing months. The average post-signal return of 10.75% at six months out more than doubles the small-cap ETF's anytime return for this time period. Plus, the one-year returns are 100% positive (as opposed to 77% anytime), with an average return of 18.34% surpassing the norm by nearly 8 full percentage points.

iwm returns after efa-eem-iwm underperformance

The two tables below break down the individual post-signal returns for each of IWM and SPY following each of these six "SPY performance gap" flags. The signal that flashed last November 2018 was the second in a row that yielded a weaker six-month return for IWM than it did SPY -- although, following a similar discrepancy after the October 2015 signal, IWM had returned to outperformance by the time the 12-month mark rolled around.

spy-iwm post-signal returns efa-iwm-eem lag

(We've omitted similar tables for EFA and EEM due to space, but completists will want to know that EFA performs similarly to SPY after a signal -- mild underperformance at three months, followed by outperformance at six and 12 months, though with a lower percentage of positive returns than its U.S.-focused counterparts. EEM, meanwhile, lags, outperforms, and then lags a bit, but enjoys a higher percentage of positive returns after a signal.)

To add some dimension to our analysis of this price action signal, we turn to ETF fund flows -- and at first glance, this data would seem to scream "dumb money," in terms of investors running scared from the outperforming SPY. During the six-month stretch that yielded our signal above, SPY registered net outflows of $4.795 billion, according to etf.com data. By comparison, IWM recorded outflows of $2.843 billion over the period, while EEM netted outflows of only $138.90 million. In other words, investors have pulled the most cash out of the best-performing asset -- a contrarian love story, right?

However, broadening the flows data to account for funds with mirror-image price action to our focus ETFs -- specifically, the iShares Core S&P 500 ETF (IVV) and Vanguard S&P 500 ETF (VOO) for SPY, iShares Core MSCI Emerging Markets ETF (IEMG) for EEM, and iShares Core MSCI EAFE ETF (IEFA) for EFA -- a different picture emerges. For starters, VOO and IVV, which are slightly lower-cost SPY alternatives, netted combined inflows of $10.689 billion over that six-month outperformance window, effectively "erasing" SPY's coincident outflows more than twice over (at least, in terms of potential sentiment implications).

It was a similar story for the emerging markets ETFs. In contrast to the aforementioned net outflows in EEM over our lookback period, IEMG -- like VOO and IVV, a cheaper alternative -- racked up comparatively overwhelming net inflows of $4.213 billion. And in the developed markets, while EFA bled outflows of $8.431 billion, its slimmed-down IEFA counterpart netted inflows of $7.086 billion (leaving flows-based sentiment on the region "net negative," but going a long way toward bringing it back up to "breakeven").

In fact, looking at a more traditional slice of time, VOO, IEFA, and IEMG were all among the top five ETFs, on a net inflows basis, during the first half of calendar year 2019. And topping the outflows list for the first six months of the year? SPY and EFA, in the No. 1 and No. 2 spots, respectively. Given the secular shift toward lower-cost versions of the traditional ETF benchmarks, we'd advise any investor tracking fund flows as a sentiment tool to be sure and watch the money on these "bargain" funds.

That said, it's interesting to note that both IWM and its "sale price" competitor, the Vanguard Russell 2000 ETF (VTWO), registered net outflows during the six-month signal period outlined above (VTWO adds a modest $63.01 million capital drain to IWM's aforementioned $2.843 billion bleed). And while small-caps did lag SPY over this time frame, on an relative performance basis, bear in mind that IWM still racked up an impressive 9.84% gain over those six months -- more than doubling its "anytime" six-month return of 4.53% since 2011.

While it's worth proceeding with caution, as IWM post-signal returns have softened in recent years, the large-scale outflows from this traditionally "risk-friendly" sector of the market during a period of stronger-than-usual (by its own standards) price action is perhaps one reason to suspect that Wall Street's small-cap apocalypse theory is a bit overdone.


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