Small or Large Cap?

In 2000, the market cap weighted S&P500 camouflaged the
underlying weakness in the broader market. Investors focused on the indices (primarily S&P500), and as the biggest stocks rallied, they took the indices up with them. Meanwhile, a stealth sell off was being masked by the new highs

Today, the market cap
weighting is once again hiding something significant from investors:
This time, its the fact that the stock market isn’t particularly cheap. The relative cheap prices of the OEX100 (S&P100) is hiding the relative prices of the rest of the index.

Ratio

This was the subject of a fascinating column by Mark Hulbert in the Sunday Times. A looked at study of Valuation by Market Cap:

"SMALL-CAP stocks are significantly overvalued. In fact, they are
even pricier, on average, than they were in March 2000, just before the
Internet bubble burst. In contrast, the average large-cap stock is
moderately undervalued.

This picture of a highly bifurcated stock market is painted by data from Ford
Equity Research of San Diego, which tracks around 4,500 publicly traded
companies in the United States. Among companies that have been publicly
traded for at least seven years, the firm reports that 55 percent have
higher price-to-earnings ratios today than they did in March 2000. The
bulk of these pricier issues, however, are in the smaller-cap sectors.
Among the very largest companies, the average P/E ratio is now just a
third of what it was seven years ago."

That very much squares with our views on various sectors. This past Summer is when we gave the nod to big caps, on both a technical basis and as a defensive play.

How can the overall P/E of the S&P500 be so misleading? Hulbert’s answer is based on how the index is put together:

"The S.& P. 500
is a capitalization-weighted index, meaning that each company’s
contribution to it is a function of the company’s size. That would not
necessarily skew the average P/E ratio for the index itself, if the
average valuations of both larger and smaller stocks were similar. But
that’s not the situation today, according to Ford Equity Research: the
50 companies in the S.& P. 500 with the smallest market caps have
an average P/E ratio that is much higher than it was seven years ago,
while the ratio for the 50 largest-cap stocks in the index is
significantly lower".

How different? "According to Ford Equity Research, the average P/E ratio among the
50 largest-cap companies is now 19"
— thats about 30% of what it was for the grouo in March 2000. On the other hand, the 50 smallest companies P/E ratio is now 30.7 — 50% higher than it was in 2000.

Let’s revisit that earlier chart: Its clear that the relative relationship between small caps and large caps changed dramatically in August; The ratio looks to be consolidating or softening:

Oex_sml_ratio

We will have to see if that relationship undergoes a further shift in the next future . . .

>

Source:
Beyond the Bubble, With Small-Cap Stocks
MARK HULBERT
Strategies
NYTimes,  March 18, 2007
http://www.nytimes.com/2007/03/18/business/yourmoney/18stra.html

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