After a historic run, small-cap stocks recently fell sharply and bond yields also slumped, pushing towards all-time lows. Some have interpreted the shift as an indication of systemic economic weakness, with investors fleeing overpriced equities for the safety of the Treasury market.
Small-cap stocks often serve as an indicator for the broader equities market, and the Russell 2000 Small-Cap Index has fallen 10 percent since March, a troubling sign under normal conditions. Many large conservative investors—including most mutual funds and pensions—are prohibited from buying small-cap stocks, which allows more aggressive players to dominate the market. Trends in the broader equities market often emerge first in small-cap prices. For instance, a selloff that starts in the Russell 2000 may rapidly spread to the S&P 500.
However, this spring’s dip does not indicate a loss in confidence in small-cap companies, and today’s lower prices still anticipate robust growth. In December, small-cap stocks hit an all-time high against the broader market, with average forward price-earnings ratios for Russell 2000 companies topping 24—compared to an average of 15.7 among the S&P 500. Falling prices have diminished this record spread, but small-cap stocks still command historically high premiums over larger firms.
Persistent low bond yields also contribute to anxiety over the economy’s health. If the recovery is truly on track, investors should be turning away from the stability of bonds to seek higher returns in the equities market. Negligible yields on Treasuries could be a sign that investors fear stocks are overpriced.
But this likely isn’t the case. For many bond investors, the stock market has never been an option. Foreign central banks, for instance, often invest current account surpluses in U.S. Treasuries, attempting to depress their currency’s value against the U.S. dollar. Moreover, the diminishing supply of Treasury bills—what some might call an indication of market weariness—is likely the result of a shrinking federal deficit and an increased demand of international trade volume from foreign bankers.
In an encouraging sign, futures markets have not been shaken by the small-cap correction. Stable interest rate expectations indicate few investors fear the recovery will be derailed by underlying systemic weaknesses. Occasionally market fluctuations are idiopathic—in other words, not every shift in funds reflects the changing fortunes of the broader economy. Falling stocks and low bond yields might be a sign of trouble brewing, but against the present backdrop of steady GDP growth and a stable futures market, the decline in small-cap stocks should be no cause for alarm for U.S. businesses.