Small-Cap Stocks are Under-performing, Here’s What You Should Do

Westpac’s woes continue…

The CEO and Chairman are now gone.

Who could’ve seen that coming?

Well, excuse my sarcasm.

It was an outcome that was pretty clear for anyone who cared to look. And I’m not talking just this week. I’m talking months, if not years ago.

The big banks have proven themselves time and time again unworthy of the social contract they so often tout.

This current Westpac saga isn’t the start of the story, nor the end. We’re firmly in the middle phase of a great bank unbundling.

Free report: Four standout Aussie stocks to stick in your portfolio ASAP

As the Hyperion Asset Management CIO told the AFR yesterday:

Westpac’s woes suggest there’s more pain ahead for the big four banks, given the sector’s poor track record in technology investing in the pursuit of short-term profits.

Banks aren’t tech companies. They don’t think like tech companies. And they can’t compete with tech companies.

Indeed, the company is blaming a software glitch for the recent dramas.

But as my colleague Ryan Clarkson-Ledward put it to me in email yesterday, that’s not a great excuse:

When one small software bug costs you a CEO, Chairman and likely a whopping fine. God only knows how much spaghetti code must be layered on the big fours internal systems…

But I’m sure you’ve heard all this before from me ad nauseam.

So, I’ll spare you the full lecture today.

All I’ll point out is that it’s still not too late to find some big winners in this unbundling. In fintech, in regtech, and in open banking.

In my opinion, look to smaller nimble challengers with tech at their core, if you want the chance of big gains in this banking bloodbath.

With that out the way, I want to move onto something else today.

It’s an unusual divergence that, if it corrects, could see a stunning 2020 for small-cap stocks.

Let me explain…

The devil — and opportunity — is in the detail

Let’s pop over to the US markets now…

A place where stock markets are booming. Well, some parts of it are.

It’s often overlooked, but while larger companies are flying at or near record highs, their small-cap brethren are still a long way from there’s.

Here’s the S&P 500 index of the largest 500 companies in the US by valuation:


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Source: stockcharts.com

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It’s at all-time highs.

And here’s the weekly chart of the Russel 2,000, an index of small-cap stocks:


Money Morning

Source: stockcharts.com

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As you can see, the small-cap index is unable to move above the 2018 highs. And it remains a fair distance from the all-time highs (see the red circle to see how far it has to go).

The same divergence is playing out in Australia too. Small-cap stocks are significantly underperforming their large-cap peers.

Now this is unusual…

Usually when the stock market is flying, the general sentiment goes to ‘risk-on’. Meaning investors are willing to take on more risk as they get excited by the rising markets.

Small-caps are the natural beneficiaries of such sentiment.

But today that’s not the case.

Which suggests investors are still very cautious.

Indeed, if you look closer, you can use another indicator to confirm that’s the case. Look at this chart:


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Source: stockcharts.com

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This weekly chart is the NYSE advance/decline line which shows how many stocks are rising versus declining.

It’s showing that less stocks are moving higher, even as the overall index rises.

Let’s put this all together…

How will this all play out?

There are two possible scenarios that play out from here.

One is that this divergence is a signal of potential market declines to come.

As less stocks rise, it suggests more companies are struggling. And that might show up in economic conditions soon.

If that happens then the large-cap stocks will come down to meet the small-caps.

However, if it’s just the case investors are too nervous, then if that corrects, small-cap stocks are set to play catch up.

We could see a surge in small-cap stocks in 2020, as people realise things aren’t as bad as they might have feared. That’s my best guess on what will happen.

So how do you find the best small-cap stocks to jump on if that’s the case?

For my money, you want to look at industries that are in flux.

Banking is the obvious one, as we spoke about at the start. A few well-placed investments in the most promising fintechs could pay off handsomely.

Healthcare is another industry due for a big shake-up.  And again, technology is at the heart of this disruption.

I reckon change is coming to these two sectors, no matter what.

Download now: Three ASX fintech stocks taking on the banks (and winning)

But a nice market tailwind as investors move back into the small-cap arena in 2020 would be a nice boost too.

Make sure you’re alert to signs this is happening, no matter what doom and gloom headlines you might read.

Always follow the money over the headlines.

Good investing,

Ryan Dinse,
Editor, Money Morning


Ryan Dinse is an Editor at Money Morning. He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur. With an academic background in economics, he believes that the key to making good investments is investing appropriately at each stage of the economic cycle. Different market conditions provide different opportunities. Ryan combines fundamental, technical and economic analysis with the goal of making sure you are in the right investments at the right time.  


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