Microcap stocks hit an all-time high this week. That might be a good sign of investor confidence in riskier assets, but one strategist warns it may also be setting markets up for a major fall.
According to Matt Maley, an equity strategist at Miller Tabak, when the volatile iShares Microcap ETF (AMEX: IWC) outperforms over several months, the S&P 500 typically tops out shortly after.
Small companies are generally much more risky than their larger counterparts, and excessive risk taking is often associated with a market top.
“People add more risk and they throw caution to the wind and that’s usually something we see at the end of the cycle, not at the beginning,” Maley told CNBC.
Since 2007, there have been six previous instances of the iShares Microcap ETF outperforming the S&P 500 Index. In five out of the six, Maley notes that the S&P 500 reached a top relatively soon thereafter.
“It’s not a perfect indicator but it does tell me that we may be getting to see another hiccup in the market sometime in the next couple of months, kind of like what we saw back in February,” Maley said.
Microcaps are companies with market caps between $50 million and $300 million. The iShares ETF includes the 1,000 smallest stocks by market cap in the Russell 2000 Index.
On June 6, the iShares Microcap ETF reached an all-time high close, and is up nearly 12% year-to-date. By comparison, the S&P 500 has risen by 3.7%, but is down 3.5% from its record high close on January 26.
Stacey Gilbert, a market strategist at Susquehanna, has said that a strong U.S. dollar and robust domestic economy may spur the rally in microcaps to keep going. While the dollar is strong, microcaps tend to outperform against multinationals as more than two-thirds of microchip revenue is generated domestically.
But Gilbert says investors should employ stock selection when looking at microcaps.
“Like all ETFs, you have to open up the hood to figure out what’s actually in there and some of the liquidity of some of these smaller-cap names can be very tight,” Gilbert said. “I would be picking my favorite stocks in microcaps rather than buying something broader so that I know my risks going into it.”
The five biggest holdings in the iShares ETF as of April 30th were:
- Arena Pharmaceuticals (NASDAQ: ARNA) – Up 40.59% YTD
- Immunomedics Inc. (NASDAQ: IMMU) – Up 57.43% YTD
- AnaptysBio Inc. (NASDAQ: ANAB) – Down -28.06% YTD
- Heron Therapeutics Inc. (NASDAQ: HRTX) – Up 73.48% YTD
- Enanta Pharmaceuticals Inc. (NASDAQ: ENTA) – Up 90.39% YTD
AnaptysBio is a prime example of the inherent risks of microcap companies. Shares of the biotech stock hit a high back in March and have since fallen over 40%.
The stock was propelled to a high on promising results from an eczema treatment trial. But the same drug, when tested as a treatment for peanut allergies, proved to be less promising sending the stock crashing as analysts expressed disappointment.