A trader scratches his head as he watches his screens on the trading floor of Frankfurt stock exchangeRALPH ORLOWSKI
Small cap stocks in the United States and elsewhere have enjoyed an impressive run ever since the economic recovery kicked in, outperforming their large-cap brethren by a wide margin. But with the recovery shifting to economic expansion, is there more room for outperformance?
Pierre Lapointe and Alex Bellefleur at Brockhouse Cooper think not. While small stocks typically perform better than large stocks during the first 12 months of an economic recovery, this trend is lasting a little longer this time. This has created stretched valuations relative to large-cap stocks.
The trailing price-to-earnings ratios for stocks in the S&P 600 small cap index are usually lower than the P/Es for the large cap S&P 500 index. Not now: The P/E for the small cap index is 30 per cent higher, marking a 30-year high. Small cap stocks look expensive on a price-to-book basis, too.
Given these high valuations, Mr. Lapointe and Mr. Bellefleur believe that small cap stocks would need another catalyst to maintain their lustre - perhaps something along the lines of another stimulus effort from the Federal Reserve, in the form of a new round of quantitative easing.
"QE2 provided such a catalyst last fall, as massive liquidity injections helped to propel 'junkier' assets higher," they said in a note. "Another round of QE could provide another catalyst for small caps, but given the recent rebound in inflation and our anticipation of strong job creation in the coming months, we simply do not think there will be a QE3."
In other words, they favour large cap stocks, given the signs of ongoing improvements in the economy.
"At this point, the risk-reward trade-off for small caps no longer appears attractive. We reiterate our overweight recommendation on equities, but large caps look much better to us than small caps."
David Berman