Why Anxious Investors' Pressure Could Push Small Cap Stocks Lower

NEW YORK (TheStreet) -- Small cap stocks could continue to sell off this week as global events drive volatility higher.

iShares Russell 2000 Index (IWM) has fallen close to 2.5% over the last three trading sessions as investors have pushed the iPath S&P 500 VIX ST Futures ETN (VXX)  up almost 9% since the beginning of September, fearing uncertainty in many of the world's largest economies.

Among the Russell 2000's top holdings are InterMune (ITMN) , Isis Pharmaceuticals (ISIS) , Kodiak Oil & Gas (KOG) , Puma Biotechnology (PBYI)  and WEX (WEX) .

The chart below shows the inverse relationship between volatility and small cap stocks. Small cap stocks are generally viewed as more speculative than large cap stocks as small caps are dependent on capital gains for total return compared with most large cap stocks, which generate both capital gains plus a dividend.

The total return aspect is important because even as large companies such as AT&T (T) see share prices decline, the investor is receiving not only a dividend, but the company may be buying back shares as well.

In some cases, financial engineering by large cap stocks can turn a slightly negative year for a company's share price into a positive return for investors.

Small cap stocks, reliant on capital gains and growth, have better uses for free cash flow than distributing it to investors. They can invest in new projects or take on strategic acquisitions to further grow revenue, and hopefully profits as well.

This is a positive aspect in times of market exuberance, but when investors are fearful, they sell speculative positions in favor of stability. This ultimately leads large caps to relatively outperform small cap stocks as investor confidence wanes.

IWM Chart
IWM data by YCharts

Although volatility has been largely absent the past few months, key events this week threaten investor confidence, potentially leading to the relative underperformance of small caps as discussed above.

Chinese data weighed on investor confidence earlier in the week as industrial output underwhelmed.

Reports over the weekend showed China's industrial production grew by a 6.9% annual pace in August, down from the 9% growth recorded in July, representing its weakest reading since December 2008.

Weak industrial output led many Wall Street banks to negatively revise China's full year growth projections to the low 7% range, potentially spilling over to weaker demand for commodities and resources across the region.

Meanwhile, in the United Kingdom, fear that Scotland could become independent of Great Britain is also driving volatility higher.

Recent polls show that the decision between Scots sticking with the U.K. or becoming their own independent country is a dead heat, possibly leading to the demise of the 300 year-old union between the two countries.

Investors are uncertain about the economic ramifications if Scotland does break away, leading to volatility and selling of CurrencyShares British Pound Sterling (FXB) and iShares MSCI United Kingdom ETF  (EWU) ahead of Thursday's vote.

Uncertainty regarding future monetary policy in the U.S. is also contributing to the increased volatility.

Market observers expect the Federal Reserve to offer a more hawkish tone on policy Wednesday as the U.S. economy has steadily improved in 2014.

Tighter policy, however, could lead to higher interest rates, and potentially weigh on economic growth, just as the economy is beginning to gain momentum.

The culmination of global events taking place this week has led to increased uncertainty amongst investors. Anxiety is showing up as volatility in equity markets, causing selling pressure on high-beta, small cap stocks.

If the market does not like what it hears from the Fed, Chinese growth continues to deteriorate, or Scotland dissents from the U.K., the Russell 2000 could rapidly accumulate losses as it moves towards lows on the year. 

At the time of publication, the author held no positions in any of the stocks mentioned.

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This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.


TheStreet Ratings team rates INTERMUNE INC as a Sell with a ratings score of D-. TheStreet Ratings Team has this to say about their recommendation: 


"We rate INTERMUNE INC (ITMN) a SELL. This is driven by several weaknesses, which we believe should have a greater impact than any strengths, and could make it more difficult for investors to achieve positive results compared to most of the stocks we cover. Among the areas we feel are negative, one of the most important has been generally deteriorating net income."

You can view the full analysis from the report here: ITMN Ratings Report

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