Timing small caps vs. large caps using valuation

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Beliavsky
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Joined: Sun Jun 29, 2014 10:21 am

Timing small caps vs. large caps using valuation

Postby Beliavsky » Fri Jan 06, 2017 9:32 am

In a Jan 5 2017 report "Small/Mid-Cap Valuations: Small caps partied more than in 1999",
BOAML strategists Dan Suzuki and Jimmy Bonilla write as follows:

Small caps are trading back at cycle-high valuations The forward PE of
the Russell 2000 rose to 19.0x in December, tying December 2013 as the
high for the cycle. Current levels are also in-line with “Tech Bubble”
valuations and higher than at any point in 1999-2001. The Russell 2000
has only traded above 19x for a total of six months in the past 38
years. As a result, small caps now trade at a doubledigit premium to
their historical median since 1985 across four of the five valuation
metrics we track, led by PE to growth at a 66% premium. The current PE
is 25% above its historical median of 15.2x since 1985. Importantly,
the 19x forward PE multiple excludes over 20% of the Russell 2000’s
market cap as outliers. Including outliers and non-earners would
increase the PE by seven multiple points (+35%) to 26x. Overall,
valuations across size segments expanded in December as all size
benchmarks posted gains for the month. Relative to their historical
median valuations, small caps are the most expensive size segment on
forward PE, trailing PE and PE to growth while mid caps are the most
expensive on P/BV and P/Sales.

I wonder if valuation measures can be used to time positions in large cap stocks
vs. small cap stocks. You may not want to aggressively trade and realize capital
gains based on such measures, but they could tell you where to invest new money
or how to allocate a tax-deferred account.

garlandwhizzer
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Joined: Fri Aug 06, 2010 3:42 pm

Re: Timing small caps vs. large caps using valuation

Postby garlandwhizzer » Fri Jan 06, 2017 11:44 am

Small caps and SCV in particular have had quite a run in the past year. Some of this is the natural swing in the pendulum from the preceding years in which SC underperformed LC and V underperformed G for a period of years. Assets have moved into SC and particularly SCV in the past year for a number of reasons including the desire to prefer investment in the US domestic economy (SC concentrates here) rather than the global economy (50% of S&P profits come from outside the US). As the US economy's growth prospects diverged from other INTL economies where growth remained either absent (DM) or slowing (EM), investors tended to move from LC into SC which concentrates its revenues domestically and especially SCV whose underperformance over the prior decade left their valuations quite attractive relative to other domestic alternatives.

Now after this positive action in the last year as the article points out, SC is fully/richly valued but it must also be pointed out that so is LC which also has enjoyed a nice but less spectacular run. Has SC overshot and due for a drop? Have both SC and LC overshot? Hard to say, but what is clear is that there is a lot of good news baked into the prices of both now. If US economic growth takes off in 2017 as some expect from a Trump administration-Republican Congress business friendly approach these rich valuations may be justified by corporate profit growth. However, and this a big however, there are clouds on the horizon--increasing interest rates, increasing inflation, anticipated increasing governmental debt due to anticipated lower tax rates plus increased infrastructure spending, and the possibility of a global trade war brought on by increased tariffs.

So in my view, the recent SC outperformance and resultant higher valuations may either increase, decrease or remain stable depending on how this complex picture works out. Nothing in the US looks cheap to me now so if you move from SC where do you go? What is also worrisome to me is that investor sentiment is so positive now, approaching extreme levels that historically often precede market corrections. The market has come a long way based largely not on the present but on very optimistic future expectations for our economy which may or may not work out.

Garland Whizzer

livesoft
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Re: Timing small caps vs. large caps using valuation

Postby livesoft » Fri Jan 06, 2017 12:10 pm

I think the market will tell you about any timing decisions that you need to make, so you don't have to worry about valuations since other market participants are probably doing that for you.

To wit, you just need to do the normal buy-hold-rebalance thing.

You should have a rebalancing plan that forces you to sell small-caps while not selling large-caps and vice versa.
You should have a rebalancing plan that forces you to buy small-caps while not buying large-caps and vice versa.

The reality is that one is never going to a 0% allocation to large-caps nor a 100% allocation to large-caps.
The reality is that one is never going to a 0% allocation to small-caps nor a 100% allocation to small-caps.
One is always going to own large-caps and small-caps and just rebalance around the edges.
One can have large edges, but that should be in your Investment Policy Statement and rebalancing plan.

The above has worked for me quite nicely.
This signature message sponsored by sscritic: Learn to fish.

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billyv
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Re: Timing small caps vs. large caps using valuation

Postby billyv » Fri Jan 06, 2017 1:40 pm

Two reasons to hang on to small caps: first, any lowering of US corporate tax rates (reportedly a high priority of the new administration) will benefit small and mid cap companies more than large multinationals, which tend of have more opportunities to shelter profits overseas. Second, a strong US dollar will tend to benefit companies that do a larger share of their business in the US (i.e. small and mid caps) more than large companies. For either/both of those reasons, small caps may not be as overvalued as their appear.

LibertyLover
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Re: Timing small caps vs. large caps using valuation

Postby LibertyLover » Fri Jan 06, 2017 2:22 pm

Two follow ups to the small cap valuation discussion..

1. Small cap valuation should be considered against the valuation of large caps. I've had trouble finding the historical ratio of the two asset classes. Dating small caps p/e ratio is high is somewhat irrelevant of large call is also high.

2. Due to accounting changes it appears we can't compare past p/e valuations to current without resetting what the new normal is according to today's accounting methods.

lack_ey
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Joined: Wed Nov 19, 2014 11:55 pm

Re: Timing small caps vs. large caps using valuation

Postby lack_ey » Fri Jan 06, 2017 2:46 pm

Generally I think you should be as wary of timing the size factor as you might be for the market factor. Maybe there's a small statistical edge to be had but it's definitely not easy and count on being wrong a whole lot.

LibertyLover wrote:Two follow ups to the small cap valuation discussion..

1. Small cap valuation should be considered against the valuation of large caps. I've had trouble finding the historical ratio of the two asset classes. Dating small caps p/e ratio is high is somewhat irrelevant of large call is also high.

2. Due to accounting changes it appears we can't compare past p/e valuations to current without resetting what the new normal is according to today's accounting methods.

You can check at least historical P/B which should say at least moderately similar things.

This about a year old:
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