After seeing paltry returns for most of 2014, advisors might wonder if it is time for U.S small-cap stocks to shine again. After all, if they compare the performance of the Russell 2000 with the S&P 500, small caps have a fairly long history of outperforming large caps.
But many strategists and analysts think small caps are a long way from reclaiming their role as market leaders. "Even with small caps lagging, the valuations in our view are still well above long-term averages," says Kate Warne, investment strategist at Edward Jones in St. Louis. "We are recommending investors reduce their holdings of small-cap stocks."
The numbers show that small caps struggled for most of 2014. The Russell 2000 gained only 0.96% as of Dec. 17, 2014, while the S&P 500 was up 8.90%. In 2013, by contrast, the Russell 2000 zoomed ahead by 28.99% while the S&P 500 rose 23.38%.
And yet the U.S. small-cap sector is seen as still overvalued. S&P Capital IQ says that both the Russell 2000 and the S&P SmallCap 600, which normally trade at a 20% premium over the S&P 500, are "trading at a 40% premium," signifying that small caps as a whole are significantly overpriced, according to Sam Stovall, chief equity strategist at S&P Capital IQ.
But while the sector current values may not be justified overall, some experts note that a diligent searcher may find gems overlooked by the market. "The takeaway is it's always good to have some exposure to large, mid-cap and small-cap stocks, but now may not be the time to establish an overweighted position" in small caps, Stovall says. "But that's not [to] say you should stay away entirely. There are small-cap names where we have very favorable recommendations."
Edward Jones identifies small-cap companies with high expected growth rates as one category in which valuations have become particularly lofty.
These "high excitement stocks" include companies in the biotech, cloud and social media spaces. "Investors seem to [be] projecting fast earnings growth or, in some cases, only fast sales growth as some of the companies do not have much in the way of earnings," Warne says.
Warne also sees an overabundance of investor zeal for utilities and other high-yield small-cap sectors. Within this group, "the yields are not as high as they were, but they are still high compared with other areas of the market," she says.
For its valuation metric, Edwards Jones tracks the trailing 12-month price-earnings ratio and uses the S&P 600 index rather than the Russell 2000. In mid-December, the trailing 12-month price earnings ratio was 32.2. That compares with a long-term average price that is 22.9 times earnings. That puts trailing P/E ratios at nearly 41% above historic trends.
Why have small caps reached such high valuations? Warne believes that investors have seen small stocks lead the market rebound since it began in 2009 and they mistakenly expect this leadership role to continue. "Unfortunately, as the cycle begins to change, it's not likely the leaders in the first phase of the cycle are the leaders going forward," Warne says.
Something similar has happened with consumer discretionary stocks in the S&P 500. While those stocks led the way for the first five years of the market recovery, they lagged in 2014, Warne points out.
Raymond James concurs that small caps are overvalued. The firm uses several price-earnings metrics in assessing the valuation of the Russell 2000: trailing earnings, forward earnings, price-to-book ratio and price-to-cash-flow. Based on the findings, a standard deviation score is calculated for each metric to measure the degree to which it differs from the trailing 20-year average, according to Nick Lacy, director of institutional research at Raymond James in St. Petersburg, Fla., who oversees a team that runs the asset allocation for the discretionary portfolio.
"At the peak, toward the end of 2013, most metrics showed that prices for the Russell 2000 were two standard deviations above its normal valuation," Lacy says. "Since the small caps have sold off somewhat compared with large caps, we've seen that come down. But, it's still at one standard deviation above normal." Now, price-to-book is below one standard deviation while all the other metrics are above that level. "Small caps are trending cheaper, but it's going to take awhile," Lacy says.
Small caps are shedding the role as market leaders. "Small caps are the ones that typically lead us out in market recoveries," he says. "Large caps are typically are the last to lead. What we are seeing now is similar to what we've seen in history. You want to own more small caps early in the cycle, and you want to own more large caps later in the cycle."
Lacy cautions investors who may want to get add small caps to their portfolio at this point. "If you're looking for an entry point, now may not be the opportunity," he says. "But it's coming. It might not be for another year. When things sell off, they tend to sell off for a long period of time."
BlackRock, which has been underweight U.S. small caps since April, "has recently shifted its stance more toward neutral," according to Russ Koesterich, chief global strategist at the firm.
The shift is predicated in part on the fact that while small caps still look very expensive according to some traditional price-to-earnings measures, they look less expensive if you look at certain other metrics like price-to-book or even price-to-cash-flow, he notes. "So, I think the valuation arguments still favor large cap, but it's more ambiguous than it was late last winter and early in the spring."
Koesterich thinks that investors who have been underweight small caps should begin to move their exposure back to something that more reflects the benchmark weight. For investors who have been overweight U.S. small stocks, they should bring down their exposure.
Koesterich warns, however, that 2015 is likely to be a more volatile year than 2014 because of expectations that the Federal Reserve will start to raise interest rates by next summer. "People should be expecting a bumpier ride than has been the case over the last several years," he says. The volatility could be especially high for small caps, he adds.
"If for some reason the Fed has to be more aggressive, either in terms of raising rates earlier or in terms of raising rates faster, small caps are arguably more exposed than large caps," Koesterich says. He expects that small caps would be more negatively impacted than large caps by a more aggressive Fed, based on how they have performed in the past when real interest rates have risen. "The way I frame this is that the Fed remains a risk factor particularly for the small-cap universe," he says.
PRICES IN A CRATER
Morningstar senior analyst Laura Lallos warns against selling small-cap stocks and small-cap funds now when so many have declined this year. "Now is not necessarily a good time to be selling," Lallos says.
Net fund-flow data from Morningstar shows, however, that investors fled U.S. small-cap funds steadily from April to November with a net outflow of $14.87 billion from small-cap funds.
Morningstar still gives a bronze rating to the Buffalo Small Cap Fund (BUFSX), which rose 44.15% in 2013, but which had fallen 10.48% this year as of Dec.16, 2014. Lallos also likes the Invesco Small Cap Growth Fund (GTSAX), which Morningstar rates silver. This fund rose 39.9% in 2013 and has risen another 2.65% as of Dec. 16.
For investors who want to add small caps to their portfolios, S&P Capital IQ rates 12 stocks as strong buys: Meritage Homes (MTH), E.W. Scripps (SSP), Skechers USA (SKX), Parexel International (PRXL), Prestige Brands Holdings (PBH), Celadon Group (CGI), Korn/Ferry International (KFY), Blucora (BCOR), Synnex (SNX), TriQuint Semiconductor (TQNT), Clearwater Paper (CLW) and South Jersey Industries (SJI).
Robert Stowe England is a contributing writer for On Wall Street and author of several books on financial markets.