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Richly Valued Small Caps Could See Rough Times Ahead

Michael Santoli
Michael Santoli
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A Wall Street sign outside the New York Stock Exchange

A Wall Street sign is pictured outside the New York Stock Exchange in New York, October 28, 2013. REUTERS/Carlo Allegri

Small has sizzled for so long in the stock market that it’s easy to forget the times investors thought big was beautiful.

But based on how well smaller stocks have done compared to heftier ones for more than a decade – and how expensive they’ve become versus blue chips – it’s become quite risky to bet on further leadership by the small-capitalization sector. While small-cap indexes still appear sturdy, and are beneficiaries of today’s high-liquidity markets, they are now valued richly enough that they stand to deliver poor returns over the next several years.

The final phase of the late-‘90s tech bubble was dominated by the largest stocks – many of them made big not because the companies had huge revenue but because the market inflated their value.

In the years since, small stocks have built up a massive advantage no matter how one frames it. This year the small-cap Russell 2000 is up 27.3%, compared to 22.1% for the big-cap Standard & Poor’s 500. The five-year advantage through Oct. 31 is 17% to 15.1% annualized; in the 14 years since small fries took the lead, the Russell 2000 has delivered 8.4% a year versus 3.8% for the S&P 500. 

^IUX data by YCharts

Smaller stocks usually benefit from the kind of low-interest-rate, loose-credit, high-risk-appetite environment that has prevailed since the financial crisis – and indeed also was in place in the several years before the crisis. They have also been favored, via vehicles such as the iShares Russell 2000 ETF (IWM), for their focus on the U.S. economy, as Europe and emerging markets economies slumped in the past year.

A powerful uptrend

Small caps are now exaggerated versions of the overall market enjoying a powerful uptrend, reflecting a prosperous corporate sector and supported by generous monetary stimulus, but valued in such a way that multi-year forward returns are likely to be unimpressive. Many long-tenured market watchers are suggesting that either now or over the next several months, big-company stocks will likely become the better way to play any additional upside in this bull market especially as the market begins anticipating a likely step-down in the Fed’s asset buying.

The Leuthold Group, which has tracked stock-market mechanics and fundamentals since 1981, has lately characterized what we’re witnessing as perhaps “a final gasp in small-cap leadership.”

The firm calculates that, based on a variety of measures tied to underlying company profits and balance sheets, small stocks trade at roughly a 40% premium to the S&P 500 – essentially as pricey as they’ve been in the “modern era.” The firm grants that valuation alone isn’t a great clue to how stocks will do in the short- or medium-term. But at this elevation, and given that small caps are more prone to “fall of their own weight” absent a recession than big stocks, the risk-reward looks poor here.

Then there’s the Value Line Median Appreciation Potential gauge, which has served as a broad guide to equity-market opportunities since the 1960s. Value Line tracks some 1,700 stocks through mostly quantitative analysis of a company's past and projected earnings and its shares’ valuation, calculating for each one how they might perform over the next three to five years. The Median Appreciation Potential, updated weekly, is simply the median of the percentage gains expected for all stocks covered.

Because it keys off the median of such a large set of stocks, it tends to reflect smaller-stock prospects. It just fell to a 45-year low, meaning the projected upside over the next three to five years hasn't been this poor since 1968 – the peak of  a huge small-cap cycle, which gave way to a nasty downturn as huge blue chips did well for a couple more years. Today’s level of the VLMAP score is a bit below those of April 1998 and July 2007, which were great times to lighten up on smaller stocks.

After the ’68 peak, the “Nifty Fifty” market dominated by blue-chip consumer-brand stocks drove the indexes higher for a while. After ’98, it was mega-cap technology, media and industrial stocks. After July 2007, virtually no group thrived as the credit contagion spread, but small stocks were bloodied far worse.

There is certainly a defensible case being made by some for why small caps are still a decent bet – and not just because of expectations the Fed will stay ultra-easy.

Morgan Stanley strategist Adam Parker points out that, while mega-cap stocks have already achieved record-high profit margins, smaller company margins are closer to their long-term average and could easily go higher. He adds that small companies are forecast to have substantially better revenue growth. And corporate-acquisition activity has been unusually slow and should pick up, which could confer buyout premiums on littler, digestible companies.

None of that is really in question. But with such a long run of outperformance in the books and small stocks at unappetizing valuations, couldn’t one argue all those virtues are priced in?