SERIOUS MONEY:BULL MARKET cheerleaders have returned with a vengeance in recent weeks, as revealed by the publication of Wall Street strategists' latest prognostications for the new year.
The perennial bulls outdo each other to see who can concoct the most optimistic forecasts and display a level of enthusiasm not seen since stock prices approached their peak three years ago. However, the major stock market indices have barely paused for breath since late August and it is not sensible to chase an overbought market higher. It would be far more constructive to position portfolios for a likely change in market leadership during the first half of 2011.
The more than 80 per cent increase in the major market averages off the cyclical trough registered during the spring of last year pales in comparison to the performance of small to mid-cap stocks over the same period. However, the breathtaking performance has seen small and mid-cap valuations move to levels that are far removed from historical experience and appear to be increasingly divorced from reality.
The relative valuation of large-cap stocks is close to historic lows on almost any measure.
The premium afforded to large-cap stocks on price-to-book multiples relative to their small and mid-cap brethren has dropped to just 15 to 20 per cent from a peak of almost 80 per cent during the summer of 2000. Meanwhile, the discount on price/earnings multiples has increased to more than 35 per cent. The relative valuation makes little sense given the profitability advantage enjoyed by large-cap stocks that is inherently less volatile and more sustainable. Furthermore, large-cap’s relative profitability advantage is even more pronounced given the group’s lower cost of equity capital.
Experienced investors will be aware, however, that an established investment trend dies of neither old age nor expensive valuations. Fundamentals drive valuations and the momentum has clearly favoured small to mid-cap stocks during the current advance. These factors include strong earnings growth, a steepening yield curve, narrower credit spreads and diminished market volatility. However, these factors may not prove as supportive in the year ahead and could well move into reverse.
Analysts have pencilled in growth of more than 20 per cent in small and mid-cap earnings for 2011. Current expectations appear far too bullish, and particularly so, given that year-on-year earnings comparisons become increasingly difficult as the year progresses. Indeed, year-on-year growth could easily drop to single-digits during the second half of the year. The declining momentum combined with negative analyst revisions would clearly favour large-cap stocks.
The slope of the yield curve is a primary determinant of large-cap valuations relative to their smaller brethren. A steeper slope portends higher nominal growth in future and benefits the more domestic and cyclical concentration evident in small and mid-cap indices. The near one percentage point increase in 10-year treasury yields since the Federal Reserve first hinted that a second round of quantitative easing was in the pipeline, has contributed to the strong showing by small and mid-cap stocks.
Economic growth, however, is unlikely to prove as strong as the Wall Street bulls believe and this should place a cap on long rates. The relative momentum should move in favour of large-cap stocks.
Credit spreads have dropped a long way since the height of the economic crisis and the easing of financial conditions has clearly favoured small to mid-cap stocks. However, that point in the cycle where corporate management take decisions that favour shareholders over bondholders is within reach. This should prevent a further narrowing of credit spreads and tilt the investment climate towards large-cap stocks.
Market volatility has dropped to levels that are indicative of complacency and excessive bullishness. An increase in market volatility should lead to greater investor appetite for large companies. Heightened market volatility focuses investors’ attentions on liquidity and quality. Large-cap stocks offer investors the ability to trade both quickly and in size, and also satisfy the desire for quality investments due to their credit ratings. The shift to large-cap amidst rising market volatility has persisted through several market cycles, and the phenomenon is likely to repeat in 2011.
Fundamentals have supported the performance of small to mid-cap stocks since the cyclical bull market began 21 months ago. The price momentum, however, has driven these segments of the market to valuation extremes that cannot be justified. The fundamental appeal is likely to deteriorate in the year ahead, and investors would do well to consider the merits of large-cap stocks.
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