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Small caps are leading in November

By November 16, 2020 No Comments

For much of the last few years, the stock market has been led higher by the technology sector. But in the last few weeks we’re seeing a much broader stock market rally, both in the US and abroad. This latest rally is being led by small cap and international stocks, two market segments that have lagged behind the S&P 500. We’re not here to predict if these new trends will last, but rather want to highlight just exactly what’s been going on recently.

Small cap & International stocks play catch up

Through October, the trend in the market had been pretty consistent this year. The S&P 500, which is a large-cap index dominated by five tech stocks, was the best performing major market index. You can see this from the chart below, which compares ETFs from each market segment. SPY represents the S&P 500, IWM represents US small caps, and VEA represents Japan, Europe, and other international markets. SPY was up 2.70% on the year through October compared to losses of 6.25% and 8.75% for US small caps and international stocks, respectively:

Through October, SPY was more than 8% higher than both of these market segments. However, since the calendar rolled over to November, it’s been a much different story:

US small cap stocks (IWM) are up nearly 16%, while international stocks (VEA) are up more than 13.50%. Meanwhile, the S&P 500 (SPY), while still up considerably, is starting to lag behind a little bit at +10.90%. Whether this outperformance for small caps and international stocks continues or not is anyone’s guess. But it is what’s going on right now and it is helping diversified portfolios perform better than they had been through October.

Value vs growth

Another big storyline all year has been the underperformance of value stocks versus growth stocks. Bank stocks like JP Morgan (JPM), for example, are considered value stocks. While tech stocks like Apple (AAPL) are considered growth stocks. Year-to-date, AAPL is up 63% compared to a 12% decline for JPM:

But since November began, JPM is actually up 19% compared to an 11% rise for AAPL:

The difference between value and growth stock has a lot to do with how various market segments perform. The S&P 500, for example, is arguably a “growth” index. The top five holdings are all tech stocks and they account for 22% of the index. In general, technology dominates the index, accounting for 34% of the index’s total allocation. Financials like JPM, which are classified as “value” stocks, account for only 12% of the index. Compare that to the small cap ETF highlighted above, IWM, which has only a 14% allocation to the tech sector but a 21% allocation to financials.

IWM sector breakdown up top, SPY on the bottom

In this case it’s important to remember that one index is not necessarily better than the other. And growth is not necessarily better than value. Sure, one index or segment may have performed better than the other over a period of time. But that performance says very little about what to expect in the future.

Index construction matters

SPY has performed much better than IWM mainly due to index composition. The S&P 500 just so happens to have more exposure than IWM to the technology sector and less exposure to the financial sector. And that’s been a great recipe for success this year as tech stocks have soared. But this wasn’t a fault of either index or a credit to any prominent fund manager. Both are passive indexes, and IWM is actually more diversified than the S&P 500. For whatever reason, tech stocks have done much better than all other sectors this year. That’s benefitted SPY because it has a higher concentration in tech whereas IWM does not.

However, in November we’ve started to see more diversified ETFs like IWM outperform SPY. While we can’t say if this will continue, the recent trend has been a nice reminder of why owning a diversified group of market segments pays off. Predicting outperformance is hard. It’s much easier to own a diversified portfolio and reap the benefits of random outperformance from different areas of your portfolio. Remember, a diversified portfolio is usually going to offer a much smoother ride in the market than a concentrated one.

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