Time for Small Caps?

Summary—Go small in the U.S.
At the beginning of this year, two consensus views were
predominant. The U.S. was the place to be invested and large
U.S. blue chip stocks was the play. We think both popular
views will prove disappointing this year. U.S. stock returns
are already trailing international markets and a few significant
factors suggest small-cap stocks may soon gain leadership.
First, investors are pessimistic about and under-allocated toward
small-cap stocks. Small caps underperformed large caps
by a wide margin in 2014 and have been mostly disappointing
for the last several years. In recent years, net new flows into
large-cap ETFs have far outpaced new flows into small-cap
ETFs. Not only does this reflect investor pessimism (often
evidence of poor sentiment toward an asset class is a good
sign it is near a bottom) but also suggests most investors are
now under-invested in small caps.

Second, for the first time in this recovery, the relative P/E multiple
(based on future one-year average earnings estimates)
for small-cap stocks recently declined below its 20-year average!
Indeed, based on this valuation metric, small-cap stocks
are no more expensive today than they were in the early
2000s or in the mid-1990s!

Finally, small-cap stocks traditionally perform poorly when
inflation declines (or when deflation fears emerge as they did
in 2014). However, we expect a synchronized global economic
bounce this year and for U.S. inflation indicators to rise mildly.
This should help improve small company operating leverage
and help small-cap stocks regain leadership.
Investors should consider augmenting exposure to an asset
class which is currently under-owned and significantly out
of favor, which has recently declined to its cheapest relative
valuation of the recovery and which is likely to soon begin
enjoying a much more hospitable economic environment (i.e. re-inflation).



I think I read in a Lynch book, perhaps Beating the Street, that ideally one should be in small caps at the start of a recovery and in large caps at the end of one (prior to the next downturn). Not sure if that counts as conventional wisdom or not, but if so perhaps that’s why people are invested more in large caps currently?