Time to Reduce Some Small Caps? by Todd Sullivan, ValuePlays
I think it is time to consider an adjustment to Small Cap allocations.
The performances of the Russell 2000 (INDEXRUSSELL:RUT) (Small Cap stocks), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) (Large Cap US) and the MSCI EAFE (Large Cap International) indices are shown in the 3 charts below. The actual prices have been scaled and do not represent the actual indices but the performances from month to month are what matters.
What can be noted is that US Small Caps as represented by the Russell 2000 Index has in the past couple of years accelerated to well above its recent historical trend providing investors with 238% gain since the lows formed in early 2009-see 1st chart.
The Russell 2000 performance has out paced the SP500 by ~25%-see Chart 2.
The SP500 has outperformed the MSCI EAFE Index by more than 60%-see Chart 3.
My recommendation is based on 3 points:
1) The Russell 2000 is not likely to fall from its lofty level till the SP500 enters a significant correction which I estimate is still 5yrs-7yrs in the future. You can see how the Russell 2000 correlates with the SP500 in Chart 3. Nonetheless, the Russell 2000 is at an elevated level and carries significant risk of underperformance relative to the gain of 238% since 2009 in my opinion.
2) The SP500 even though it sits a little above fair value today still appears poised to benefit from Momentum Investors responding to continued economic expansion the next 5yrs-7yrs.
3) The MSCI EAFE which has underperformed is very likely to repeat past performance as global economic conditions improve.
The recommendation is to eliminate the Domestic Small Cap allocation over the next 12mos and redeploy these funds into Large Cap Equities. My recommendation is to have portfolios maintain current Natural Resource positions and add to Large Cap such that investors hold the remainder in a 60% Domestic Large Cap/40% International Large Cap mix.
There is no means available of identifying with precision exactly when one should adjust a portfolio or by how much. The best one can do is to assess where the greatest risks exist in various asset classes and make educated guesses based on as much history as we have available.
We have time to effect this reallocation and I think we can wait till the Russell 2000 has recovered from its recent ~7% decline. We can also make the change when it is convenient over the next 12mos. With the markets generally improving, I do not see any immediate need to rush, but there is no reason not to make the change sooner than later either. I think that Large Cap Equities are likely to outperform as investors and wake up to an improving economy.