Is The Small Cap Outperformance About To End?

The outperformance of small capitalization stocks has been one of the driving forces of the market’s recovery from the March 2009 lows. But we are now at a critical level as relative valuation levels between small and large caps get stretched to such an extreme not seen in decades.

Based on analysis by Lori Calvasina, director of small-cap equity strategy at Credit Suisse, if we compare the forward PE of Russell 2000 with the forward PE of Russell Top 200, the small caps have never been this expensive:

Source: Are Small Caps Too Pricey? (WSJ)

This isn’t limited to looking at those metrics. The relative valuation of the S&P 500 index compared to the S&P 600 provides the same picture: 13.7 vs. 19. That is a ratio of 1.39 compared with 1.3 (based on the Russell indexes PE).

This cyclicality of the markets with the long term cycles in market internals reminds me of the ‘herding behavior’ that pushed the majority of stocks to trade with the indexes.

Unlike that cycle, I don’t see the relative valuation extremes provide us with a market timing edge. It only suggests that finally, Jeremy Grantham will be rewarded for his preference for large cap ‘quality’ US companies. While large caps have been cheap, they have not delivered the returns.

If small caps and large caps switch then the tone of the market will change. As will many of the breadth indicators that we watch. For example, up to now this bull market has been marked by wide participation. If large caps take the lead, the number of issues powering the bull market will decrease and eventually, the bull market will get ‘tired’ as there will be too few stocks to carry the weight of the rally.

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