Time to underweight small caps?

Recently, many market pros have argued that in U.S. equities the five-year run of small-cap outperformance has come to an end, and large-cap stocks are poised to outperform, writes J.D. Steinhilber, founder of ETF newsletter and investment management firm Agile Investing.

The implication is that ETF investors should reduce their exposure to securities such as the iShares S&P SmallCap 600 Fund (symbol: IJR) and the iShares Russell 2000 Fund (symbol: IWM) or consider re-allocating their domestic equity investments to favor large-cap ETFs such as the Standard & Poor’s Depositary Receipts (symbol: SPY), the iShares S&P 500 Fund (symbol: IVV) and the Diamond Trust Series (symbol: DIA).

At AgileInvesting.com, we base our asset allocation decisions primarily on valuation analysis at the asset class level.  We believe it is appropriate to vary the level of exposure to an individual asset class if the data objectively show that the asset class has reached an extreme level of valuation, either on an absolute basis or relative to other asset classes, which represent alternative investment choices. Let’s examine what the evidence is currently telling us with respect to small-cap U.S. stocks.   

The current reservations about small-caps may stem from the sheer magnitude of their price outperformance over the past five years.   The annualized returns of small-caps surpass those of large-caps by a wide margin on a one, three and five year basis.

Small-cap outperformance in recent years becomes even more dramatic when viewed on a total return rather than an annualized return basis.  An investment in the S&P SmallCap 600 five years ago would be worth 65% more today, while an investment in the S&P 500 would still be underwater.

Based on this data, it is tempting to lock in profits on small-caps.  Before rushing to the exits, however, it is well to consider that small-cap’s recent run may have largely served to offset the long stretch of large-cap outperformance in the late 1990s.  Large caps outpaced small caps by as large a margin in the five years ended June 1999 as small caps have outperformed large caps in the past five years.  As a result, on a ten-year basis, the annualized returns of the two asset classes are much closer together. 

Interestingly, the tendency for small-caps and large-caps to have alternating, multi-year periods of outperformance is not confined to the past decade.  Comparing the difference in rolling five year annualized returns between large and small caps over the past 20 years, we see that four different relative performance cycles of similar duration are evident.   

In addition to examining historical price performance, another useful tool to assess the relative attractiveness of these two asset classes is to measure their current valuations in reference to fundamental measures such as earnings, book value, and dividends.

Based on the P/E and dividend yield data, the current “spread,