Will Struggling Small Caps Bring the Next Crash?

Since suffering a terrible May, large-cap U.S. stocks have recovered nicely. The health of the three-year-long bull market, however, may hinge on the thousands of smaller stocks that typically don't make headlines. With smaller stocks having thus far been unable to regain as much of their recent losses as their larger counterparts, are large-cap stocks primed to outperform for the foreseeable future -- or is the entire market at risk?

The eternal tug-of-war
Small-cap and large-cap stocks endlessly take turns in topping each other's performance. During the market meltdown in 2008 and 2009, small caps did worse than large caps, as the financial crisis pushed many small companies to the brink of bankruptcy. Yet when the market recovered, small caps posted impressive gains, as those surviving companies recouped huge portions of what they had lost.

That experience matches up with how small caps and large caps generally perform against each other. During bull markets, small-cap stocks tend to outperform, as smaller stocks have more room to run and fare better during the periods of overall economic growth that tend to accompany favorable movements in the stock market. Conversely, when times get tough, large companies have the stability and reliable customer base to get through them, whereas small companies are put to the test to see if they can make it until conditions become favorable again.

Why are small caps falling behind?
Recently, though, small caps appear to have gotten ahead of themselves. Looking at simple valuations, the Russell 2000 sports an earnings multiple of 33 times trailing earnings, and while that's down from 49 this time, it's definitely on the pricey side compared to the S&P 500's P/E of 15.

Moreover, future earnings estimates are extremely optimistic, with the index's forward P/E implying that overall earnings for the index's components will more than double in the next 12 months. Given the already substantial growth in the last year, those projections are quite ambitious -- and with current valuations high, any shortfall could leave small-cap stocks poised to plunge.

That's likely what's behind the performance of small caps in the recent mini-correction. In April, small caps were even more richly valued, and so it isn't as surprising as it might otherwise be that the Russell 2000 remains more than 10% below its recent peak value while large-cap indexes have recovered to within mid-single-digit percentages of multiyear highs.

Focusing on value
But just because the overall Russell 2000 is richly valued doesn't mean that every company is expensive. Doing some digging can reveal some fairly cheap-looking stocks. But even though the following small caps all have cheap earnings multiples of between 5 and 10, most of them have some pretty big risks:

These stocks may have low price tags, but they're far from obvious bargains. If things go well, then everyone will look back at the opportunity their low share prices represented -- but there's no guarantee that things will go well.

Don't panic
With most news sources focusing on the Dow and other large-cap indexes, you won't necessarily hear about any future drop in small caps unless you're paying close attention. Given their current valuations, some declines in small caps overall may be warranted. Only if a sustained drop comes for small caps is it likely to trigger an end to the bull market for stocks overall.

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Fool contributor Dan Caplinger likes stocks big and small. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Bridgepoint Education and Power-One, as well as writing puts on Bridgepoint Education. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't let you fall behind.


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