What's Ahead for Small Cap Stocks?

 
I had the chance to go hear Lori Calvasina, Small/Mid Cap US equity strategist at Credit Suisse yesterday.

Smaller stocks have been on a tear for the last few years, and have handily outpaced the performance of their larger cap brethren.

Through the end of November 2013, for example, the S&P Small Cap index is up +42% for the past 12 months compared to the S&P Mid Cap index +30% for the same period.  Meanwhile, the S&P 500 is "only" up +27% over the past year.

Longer term, as the chart above shows, small and mid cap stocks have risen +60% more than larger cap stocks over the past 5 years.

The question I had for Lori:

Can this continue into next year?

First, some background.   After their recent run, the valuation of small and mid caps stocks is very rich by historic standards.  Here's an excerpt from an article posted on Yahoo Finance written by Michael Santoli (I added the emphasis):

The Leuthold Group, which has tracked stock-market mechanics and fundamentals since 1981, has lately characterized what we’re witnessing as perhaps “a final gasp in small-cap leadership.”

The firm calculates that, based on a variety of measures tied to underlying company profits and balance sheets, small stocks trade at roughly a 40% premium to the S&P 500 – essentially as pricey as they’ve been in the “modern era.” ...

Then there’s the Value Line Median Appreciation Potential gauge, which has served as a broad guide to equity-market opportunities since the 1960s. Value Line tracks some 1,700 stocks through mostly quantitative analysis of a company's past and projected earnings and its shares’ valuation, calculating for each one how they might perform over the next three to five years. The Median Appreciation Potential, updated weekly, is simply the median of the percentage gains expected for all stocks covered.

Because it keys off the median of such a large set of stocks, it tends to reflect smaller-stock prospects. It just fell to a 45-year low, meaning the projected upside over the next three to five years hasn't been this poor since 1968 – the peak of  a huge small-cap cycle, which gave way to a nasty downturn as huge blue chips did well for a couple more years. Today’s level of the VLMAP score is a bit below those of April 1998 and July 2007, which were great times to lighten up on smaller stocks.

http://finance.yahoo.com/blogs/michael-santoli/small-stocks--leaders-for-years--now-face-growing-risks-135421017.html

Lori agreed that it would seem logical that the relative outperformance of smaller stocks is due for a correction. 

She noted that larger caps could benefit from the apparent recovery in Europe and Asia, since a much larger percentage of larger company revenues tend to come overseas.  Moreover, if the entire market "corrects" at some point in 2014, the fact that larger cap stocks are trading at a much lower valuation could provide more downside support.

However, Lori also thinks that the longer term case for smaller stocks remains intact.  It's not really so much that she is "talking her book", since she was a large cap strategist for Citigroup for 7 years before joining Credit Suisse.

Instead, she argued that the sheer size of the large cap stocks makes it mathematically more difficult for them to outperform over an extended period of time absent a major change in valuation similar to the late 1990's period.

In short, while Lori would suggest moving up in market cap positions from a tactical strategy, she would continue to view smaller and mid cap stocks as the best place for longer term investors.