Everyone Loves Small Cap Stocks – But What Does the Market Say?

For most of 2014 the Russell 2000 has been the red headed step child of the US equity market. Small caps ruled the roost in 2013 but lost their luster for most of this year. That is until recently. I’m currently taking the week off from CBOE which means I spend all day watching the business networks. I hear lots of positive comments regarding small cap stocks and their prospects for next year. It is one thing to hear people on TV tell us such things, but it is more important to see some numbers to back up such claims. This, as everything does in my world, leads me to VIX (and RVX).

VIX is a consistent 30 day measure of implied volatility as indicated by S&P 500 Index option pricing. RVX is also a 30 day measure of implied volatility, but uses the pricing of Russell 2000 Index options. A common method of seeing what the market thinks, risk wise, for large caps versus small caps is to compare the levels of RVX and VIX. The chart below shows the daily closing ratio for 2014 as determined by dividing RVX by VIX.

RVX - VIX 2014

When the line on this chart is at the high end of the range it may be interpreted as the market pricing more risk into owning small cap stocks than being invested in large cap stocks. This year the average RVX / VIX ratio has been just under 1.40. This is actually higher than average for the past few years.  This makes sense because for most of 2014 the Russell 2000 underperformed the S&P 500. To me a couple of things stand out on this chart.

First look back to mid-October (highlighted by the purple circle) where the ratio of RVX divided by VIX approached 1.00. Since that time the Russell 2000 is up 13.6% while the S&P 500 has rallied 12.2%. It is also worth noting that when this ratio approached 1.00 the Russell 2000 was down 6.7% for 2014 and the S&P 500 was up less than 1%. I know looking backwards is easy with respect to the financial markets, but it is interesting small caps began to match the performance of large cap stocks after the respective volatility indexes indicated less concern regarding small cap versus large cap stocks.

The other thing that stands out to me is where RVX and VIX are at this moment (or as of the close yesterday – 12/29). The ratio closed at 1.27 which is closer to the historical average and below the average for 2014. Stated plainly, everyone on TV seems to like small cap stocks in 2015.  RVX versus VIX doesn’t dispute what they are saying, at least not for the moment.