Small-cap stocks wrapped up a brutal third quarter with another slide Tuesday and the group's underperformance versus their larger cousins is rapidly becoming a line in the sand for investors.
The Russell 2000 fell 1.4% Tuesday, to a 0.3% decline for the large-cap S&P 500, closing out the quarter down 6%. That's cause for concern for investors who believe smaller companies offer a better reflection of the U.S. economy and signal turns in the broader market.
There's another school of thought though, one highlighted by
Koesterich notes that the Russell has fallen sharply from its peaks earlier this year -- down more than 9% from its July peak -- but justifies the slide by arguing that small-cap valuations are "considerably more stretched" than those of larger companies.
"U.S. small-cap stocks trade at around a 60% premium to large caps," he wrote. "That large premium -- the result of multi-year momentum-driven gains -- appears to be hurting the sector."
Among the small caps that have been reeling over the last few months:
The divergence between small- and large-cap stocks in the third quarter would seem to demand reconciliation, and in that vein there is some reason to hope it's in a positive direction for equities. According to Jason Goepfert, author of the SentimenTrader Daily Report, the other two times the Russell 2000 was down at least 5% for the year through three quarters and the S&P 500 was positive, stocks rose in the fourth quarter. Those gains were hardly consistent though: 0.7% in 1984 and 20.9% in 1998.
So do struggling small caps portend damage ahead for the rest of the market? Put Citi's chief U.s. equity strategist Tobias Levkovich in the "no" camp.
"The constant drumbeat of permabears citing equity market risks ranging from liquidity excesses to fund manager overconfidence seems to uncover frightening scenarios worthy of Hollywood horror flicks," Levkovich wrote.
"[T]he view that small cap underperformance shows a new pervasive risk-off attitude thoroughly ignores the powerful trends in certain country stock markets such as those in Argentina, Qatar and the Ukraine [that] do not intimate any sort of risk-off mentality," Levkovich added in his note to clients this week.
While he expects market choppiness ahead -- measures of volatility like the VIX have climbed of late -- Levkovich believes the bull market is still intact and won't be bludgeoned to death by the latest bout of weakness.