A strengthening microcap market shows a change too big to ignore

Everyone invested in the stock market pays attention to market trends. How is the market doing? What catalysts are fueling it, whether up or down? What patterns are emerging or failing to emerge? And so on. At The Bowser Report, we try to maintain a rather nearsighted approach, focusing on individual companies and investors rather than the overall market. Why? Because so often, our little individual microcaps don’t care what the market is doing.
Looking at microcaps as a group, however, these teeny, tiny companies have historically maintained a general trend: outperforming up markets and underperforming down markets. This simply means that when the general market is up, microcaps are up higher. Conversely, when the general market is down, microcaps are down lower. For an illustration of this, see the chart below, which shows the S&P 500, the Russell 2000 and the Russell Microcap indexes from May 1, 2012 to May 1, 2013.
microcap market chart

May 1, 2012 to May 1, 2013 chart of the S&P 500 (bottom), the Russell 2000 (middle) and the Russell Microcap (top) indexes.

This trend has held true for a number of reasons, with one standing out. Microcaps make up the majority of publicly-traded companies. From a capitalization standpoint, they make up a slight fraction of the market. As Buckaroo and Founder of Microcapclub.com Ian Cassel puts it: “the total market capitalization of the entire microcap space is around $300 billion, about the size of Google (GOOG).”

That said, it doesn’t take much capital to move the microcap market either way. When capital flows in, stocks rise rapidly. When capital flows out, stocks decline rapidly; hence the inherent volatility of smaller companies. For larger companies, it takes more to move. As a result, microcaps as a group generally rise faster and fall harder.
This summer, a deviation from this trend has developed. For a visual of this change, see the chart below, which shows the same three indexes from May 1, 2013 to August 30, 2013.
mirocap market chart

May 1, 2013 to August 30, 2013 chart of the S&P 500 (bottom), the Russell 2000 (middle) and the Russell Microcap (top) indexes.

The beginning of this chart (1) looks typical of microcap markets: outperforming the larger S&P 500 during a rise in the general market. Where the divergence becomes evident is in late June (2). All three indexes plummeted, but the smaller Russell 2000 and Russell Microcap slid about the same as the S&P 500, instead of underperforming. Then, outperformance continued into the market’s summer highs (3). Recently, the markets slid to the levels where they would end the summer (4). During this downtrend, each index above slid about 5%. Again, the smaller indexes showed little to no underperformance, as they typically would have in the very recent past.

This divergence from the norm has left many wondering why. Barron’s and The Wall Street Journal, amongst other publications, have published articles in favor of smaller stocks, touting their leverage and recent outperformance as buy indicators. Rather inronically, this is what we have been saying since the dawn of The Bowser Report.
With the economy’s increased attention to the little guys, microcaps have become benefactors of an improving market. More money is flowing to smaller companies as investor confidence grows. Government action, such as the JOBS Act, which makes it easier for small companies to find funding, has stimulated capital growth in smaller companies. All of this has led to outperformance in up markets, and comparable or smaller pullbacks during down times, signaling that much more capital is remaining in small stocks.
This could be the turning of the tide as investors become more acquainted with the lesser-known and less efficient microcap marketplace. Or, it could simply be a small blip on the radar screen of stock market history, only to correct itself. Whatever the case, the evidence is clear, marking an ongoing phenomenon too big to ignore. Whether we are witnessing the investment community finally taking small stocks seriously, or a short-term run will only become clear with time. Regardless, we will keep doing what we have been for the past 37+ years—calling attention to the exciting, ever-changing and highly-profitable world of microcap stocks.