Small stocks sink -- bad sign for economy?

August 1, 2014: 12:26 PM ET
small stocks
NEW YORK (CNNMoney)

Bigger is better in the stock market this year.

The Russell 2000, an index of smaller stocks, is down 4% this year and is trailing the other major market indexes.

It's a surprising turnaround, considering that the Russell 2000 was one the best performers last year, gaining more than 37% and coming in just behind the Nasdaq.

Small caps were even doing well this year up until recently. Almost all of the 2014 losses took place in July. The Russell 2000 slid more than 6% in two weeks after the index added some new stocks and got rid of others.

Related: The Russell had been doing great before the rebalance

Is this a cause for concern? Some investors view the performance of smaller stocks as a barometer for the economy since many small companies are more exposed to the United States than international markets.

But it may be just a simple case of investors taking a breather. Small stocks may have run too far too fast.

Some investors point to comments Federal Reserve chair Janet Yellen made about how some smaller biotech and social media stocks looked overvalued.

Related: The Fed commentary sparked some kneejerk selling

But Jim Solloway, a managing director and senior portfolio manager for SEI Investments, said Yellen didn't say anything that market experts didn't already know.

"What we've got is a pullback that doesn't forecast the end of the bull market, but does seem to be a rational reaction to the previous outperformance," he said.

Earth to investors: Don't panic!

Small caps are typically more expensive than larger stocks. But investors may be more concerned about valuation now that there is more uncertainty in the market.

The Russell 2000 is trading at 17.5 times 2014 earnings forecasts while the S&P 500 is trading at 15.2 times estimates.

And even though the U.S. economy seems to be on the mend after a rough first quarter, it's not as if the economy is growing at a robust pace. So some investors may now prefer to put their money in big multinational firms, which could benefit from more robust growth in emerging markets.

Small caps also tend to have less cash on hand for big dividends and stock buybacks -- two things that investors love about bigger companies.

Ibrahim Gassambe, a global equity strategist for Roubini Global Economics, said small caps may have a tough time catching up to larger stocks. He isn't predicting a major crash for the Russell 2000 but he doesn't think it will come roaring back either.

"I think it will be hard for [small caps] to sustain a rebound at this point," he said.

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