Relative Valuations of Small Caps Look Stretched

Historically, small cap stock returns coming out of a bear market have outperformed large cap stocks. The performance of small caps relative to large caps since the March 9th lows has been no different. The small cap outperformance tends to run for a period of around two years.

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However, this might not be the case in this market cycle. The difference this time is the relative valuations of small caps look the most stretched going back to 1983. Given the valuation gap between small and large, it appears large caps might be the better asset class at this point in the cycle.

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One factor that may serve as a tailwind for large cap stock outperformance is the fact many large companies generate significant amounts of revenue from foreign sources. With the U.S. Dollar weakening, the conversion of foreign earnings into the dollar will provide a boost to earnings growth near term. Additionally, the developing market countries are experiencing better economic growth, thus a benefit to the large multinational companies.

Comments

[PompanoFrog:]

This article is pitiful. The use of P/E ratios using current earnings has never been an accurate measure of future equity performance following recessionary periods. This type of analysis would have led to a lack of aggressive buying of equities during the last 9 months. This was one of the great bull markets in history. If an indicator can't function at extremes it should not be used.

Banks which represent a large proportion of the small cap index will start to report major earnings increases when the Fed's monetary stimulus flows into the real estate market. It is only a matter of when.

Nov 06 08:25 AM

[bartpr:]

looking at the trend of pe's after a market bottom there is a period of years in which a range is evident. the market has gone up during those years but the pe's remain in the range. this is the time that earnings have grown. increasing the denominatior by earnings means prices rising even though the pe remains constant or in a narrow range.

Nov 13 08:32 PM