There are a great many difference between small cap companies (and their stocks) and large cap companies, especially mega cap (and their stocks). That in mind, investors predisposed toward the S&P 500 are rightfully watchful of the Russell 2000. While factors displacing the latter into a technical “correction” may be idiosyncratic, no one can deny the possibility of broader implications.

First and foremost is the QE paradigm. With the third and fourth iterations both set to a predetermined end (or at least interlude) this month, it has to be taken into account in some way. Looking at any stock chart, large or small or anything in between, there does seem to be a solid correlation between QE and the uninterrupted trajectory of stocks (that includes those with far greater buybacks).

ABOOK Oct 2014 Russell Correction

For the Russell, however, the near straight line ascent, measuring about 41% from the November 2012 low, abruptly ended in early March 2014 (or perhaps late January 2014 when the first real dip was experienced). Since that point, the index has treaded mostly sideways to lower, with the current move measuring that -10% correction from the March high. Given what has transpired at the FOMC, it stands to reason that they may be some effect of the changing monetary stance – even if there is no direct connection between stocks and the “reserves” created via QE (which there isn’t).

However, there are a few additional factors to consider as to both timing and trajectory. The first quarter was, as you may have heard, overflowing with airy frozen water crystals in both practical experience and even in these indirect “markets.” Earnings on the companies within the Russell 2000 that actually have earnings were not very good in Q1. The steady downbeat of lowered expectations and even some results would have started to trickle out right around that March high.

ABOOK Oct 2014 Russell EOS

Year-over-year EPS growth in Q1 turned out to be decidedly negative at -15.6%, not only shocking in its purported sudden and unexpected fashion, but the degree to which expectations were wholly unprepared for such a reversal (despite EPS and revenue growth being mostly erratic in 2013). However, investors were re-assured by the whole economic apparatus, from Janet Yellen and her FOMC band on down, that Q2 would put to rest Q1’s nervousness.

That may have been the case with GDP, though not with much else. Investors in small caps seemed to buy that premise, at first, and the Russell headed right back up to nearly match the March peak. Now the index is on to another reversal that has yet to find its ultimate end. EPS comps for Q2 were only marginally better than Q1, which is really a decidedly negative factor. There was at that point two straight quarters of declining earnings confounding all promises and projections otherwise.

Smaller companies have always been more exposed to shifts in macro conditions than large companies, but they are certainly united in how expectations are determined and delivered. We keep hearing the economy is getting better, and analysts keep determining that will translate into corporate results, but such disappointment is not limited to 2014. The mantra of “next year” has been delivered annually, but in the case of corporate earnings the difference between expectations and results has never been so divorced, at least not in this “cycle.”

In the middle of 2013, again among more irregular fortunes that betrayed the larger macro narrative, the expectations were that 2014 would see a 30% gain in EPS to put to rest any unease about fundamentals – even as the index kept moving in almost a straight line, perhaps suggesting how QE may have played a role in relative determinations.

ABOOK Oct 2014 Russell EPS Change

Since the middle of last year, EPS estimates on the Russell 2000 have been trimmed by more than 19% (through only Q2). The effect of that sudden re-assessment of “next year” has been to see FY2014 EPS growth go from 30+% to now just 6%. As you can plainly see, however, of all the EPS presentations above, “next year” has simply been moved to 2015 where the 30+% now supposedly resides.

Can we be seeing a case where crying “recovery” too many times has lost its impact? I would think if even some of that is finding its way into investor recalibration, the diminishing psychology of QE’s end is perhaps an amplification of that possible change out of complacency. In other words, investors in 2013 might not have worried about economics and macro (and even earnings potential) when QE looked full and blooming since it was so reassuring (though I still don’t know why that would be given concurrent liquidity erosion).

Fortunes for the larger caps have fared better, but not by any large degree. Revenues continue to be “disappointing” and barely positive, while EPS on the S&P 500 has seen its share of erratic results (Q2 was just 1.8% on a GAAP basis, coming after -1.4% GAAP in Q1). Going forward in terms of optimistic forecasting, earnings find that familiar upward bend, though the level to which they are predicted to attain is lower than “usual”, while revenues actually are not supposed to get any better.

ABOOK Oct 2014 Russell SP500 EPS Revs

That seems to reinforce, actually, the negative view on the economy. Companies that have little revenue success are certainly not going to expand production and are instead going to, as they have so much in this “cycle”, over-manage costs. Profitability has become an economic curse because the actual economic pie is not expanding, or at least doing so at a highly deficient pace. So even here, predictions are not so optimistic about “next year.”

In that respect, though the indices may be along different paths at the moment (again, buybacks the difference?) there is a lot of top-down similarity. Doubts about “next year” will persist, but are now going to be on their own and outside of any QE bubble. It’s as if secular stagnation has finally come to stocks.

 

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