As a result of its 22 point decline on October 10, the S&P 500 joined an inauspicious crowd of S&P global indices in pullback, correction or bear market mode, all of which set new lows this past Friday. Here in the States, most investors are monitoring the performance of small caps, wondering whether they will drag the S&P 500 into negative territory for the year, and possibly into correction more (or worse). Excluding 2014, there have been 10 calendar years since 1979 in which small-cap stocks declined in price. Of those 10 times, nine of the S&P 500’s 10 annual returns were 3.5% or less, and six of the 10 years were negative. Finally, for all 10 observations, the S&P 500 posted an average annual price decline of 4.6%. Only in 1998 was the S&P 500 up dramatically while the small-cap benchmark declined. Therefore, using history as a guide (for its never gospel), the S&P 500 may face a challenging fourth quarter, unless the small caps stage a meaningful end-of-year rally.
Of course, no one knows for sure how much lower small-cap prices will decline in total. Should relative valuation serve as a divining rod, however, small caps appear to have farther to fall. The current relative P/E ratio for the S&P SmallCap 600 Index on a trailing 12-month basis is 1.31X versus its average of 1.20X since Q4 1995. However, the recent, broad sell-off is now offering a fundamental offset to the fear of a new bear market in the S&P 500, as seven of its 10 sectors are trading at discounts from 1% to 27% from their median multiples since 1995.
Global tensions are on the rise from ISIS to Ebola. In addition, investors are warily weighing the possibility of a “triple-dip” recession in Europe, combined with the prospects of further weakness in China. Add sobering small-cap smoke signals, and it appears as if the S&P 500 may be lucky to end the year with a single-digit gain. Until cracks in the fundamental forecasts begin to materialize, however, we will advise investors to look upon the recent weakness as a buying opportunity, especially considering the speed with which large and small caps typically recovered from pullbacks and corrections.
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