Small Caps

While the most inflated domestic-valuation readings are found in the Large Cap realm, the market rebound has driven the median 12-month trailing P/E in our Small Cap universe to 22.5x (Chart 1)—less than a point away from the June 2015 all-time high of 23.3x.

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There was a major cyclical BUY signal (VLT Momentum) for the S&P 500 in late-May, and as of July’s close, that bullish development was reinforced by a new VLT BUY signal on the Russell 2000.

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We’ve boosted equity exposure twice in the past several weeks, fully cognizant that it’s not a “textbook” time to do so.

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Small Cap valuations may look better on a relative price-to-book basis, but we still believe their Normalized P/E ratios will suffer further compression before Small Caps reclaim the leadership baton.

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After spending two months in discount territory, in March the Ratio of Ratios headed closer to its historical median premium of 4%.

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When the Fed surreptitiously began to tighten as we believe (via tapering), in January 2014, history suggested that Consumer Discretionary and Small Caps would be the most likely initial market victims (at least from a relative perspective).

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This bull market has appeared to be on shaky technical ground before, only for concerns to be swept aside. This time, we think it’s different.

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Our current view is the lift-off will be December or later. Assuming inflation will pick up and the Fed hikes the rate by the end of 2015, stocks will perform relatively well, with international stocks a better bet than U.S. stocks.

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Small Caps lagged the S&P 500 by almost ten percentage points in 2014, but their underperformance streak technically dates back to April 2011. Nonetheless, their cumulative, 45-month underperformance in relation to the S&P 500 (now about –18%) is still modest enough that any mention of the current “Large Cap Leadership Cycle” is bound to draw a few head scratches.

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The dollar’s moonshot in recent months has resuscitated a stock market leadership argument we haven’t heard for a long time.

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The recent strength in the dollar coincided with a spike in volatility and weakness in risky assets, but the relationship over the last couple years has been tenuous at best.

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With the Fed mulling over a rate increase, investors may have already started to avoid companies with excess leverage. Unfortunately, Small Caps, on average, are in this camp.

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July’s Russell 2000 -6% rout finally deflated some of the Small Cap valuation premium we’ve been grousing about in recent years.

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Small Caps have staged a nice rebound in the last several weeks. On July 3rd, the Russell 2000 rose to within a fraction of an index point of its March 4th all-time high. But on a relative strength basis, the bounce has been pretty muted.

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Based on the historical percentages, the bull market should have a minimum of four to six months of life left. But the market has a way of throwing sand in the gears when you think you’ve begun to understand its internal mechanics.

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Small Cap Premium Bounces Back To 23%

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Small Caps are selling at a 20% valuation premium relative to Large Caps (23% last month), using non-normalized trailing operating earnings.

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Small Cap Premium Continues Upward To 23%. Large Caps Lead On The Downside In January

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Small Caps are close enough to a new relative strength high that it’s possible a final revision might be necessary before the Small Cap tide flows out.

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Small Cap Premium Continues Upward To 21%. The red-hot equity market of 2013 was especially good for Small Caps with a +38.8% total return.

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