Sunday, May 22, 2011

Have Small Caps Peaked?

The rise for small cap stocks, as measured by the Russell 2000 small cap index have handily outpaced gains of large cap indices by over 50 percent since the March 2009 lows. The significant rise in the index and high valuations today show that now may be an opportune time to consider reducing overall exposure to small cap stocks.

While the jump in price of small caps as an asset class has been significant, it is unlikely to continue indefinitely. For this reason, we are now entering a phase of time when individual stock picking talent will be put to the test.

The major market benchmarks have been on a tear over the past two years. Since the bull market began in March 2009, the Russell surged 144 percent while the Dow and S&P 500 advanced 89 percent and 95 percent, respectively.
Today, the Russell 2000 small cap index is just two percent below its record high of June 29, 2007. Meanwhile, the other major market benchmarks including the Dow and S&P 500 remain 12 percent and 14 percent off their all time highs.

After such a significant advance, investors should begin to question whether the rise of small cap stocks and their current valuations are sustainable.

There is no doubt that by historical standards, small cap valuations are now stretched and likely entering a period of underperformance compared to mid and large cap stocks.

Based on price-to-earnings ratios, small cap stocks currently trade at the largest premium compared to large caps since 1979. The Russell 2000 is trading at almost 18 times one-year forward forecast earnings, reports Jonathan Cheng of the Wall Street Journal.

If we compare the forward PE of Russell 2000 with the forward PE of the 200 largest companies in the U.S., the small caps have never been this expensive:

The relative valuation of the S&P 500 large cap index compared to the S&P 600 small cap also provides the same picture as the chart above, with the large caps trading at just 13.7-times earnings versus a multiple of 19-times earnings for small caps.

When small caps trade at such a rich valuation, it often points to a pullback on the horizon. Valuations of small caps reached similar levels twice in the past, back in 1983 and 2007. In both instances, small caps started to underperform the mid and large cap asset classes. You can see the relative performance chart of small caps versus large caps stocks below.

Not only have the gains for small caps outpaced larger stocks and valuations are high, but there are other concerns on the horizon.

As you're well aware, the bull market recently celebrated its second anniversary. I suspect your portfolio, like mine, has been profiting handsomely over the last two years. But the fact that we're now two years into this bull market means that the rise for stocks may be coming to an end soon.

Over the past century there have been thirty-three bull markets with an average lifespan of 2.1 years. Only fourteen lasted over two years, and of those, only two have witnessed gains greater than the advance off the March 2009 lows. From this perspective, it stands to reason that the current bull market could be nearing its peak and running out of steam.

With small caps getting ahead of themselves, and the market in general appearing to be approaching the end of its recovery from the lows, what should individual investors be doing?

Investors may want to consider reducing broad exposure to small caps in index funds or mutual funds, and look to replace some of these holdings with investments in more attractively valued mid or large cap stocks. Additionally, they may want to consider focusing on individual stocks that offer attractive growth and trade at decent valuations.

It's a Stock Picker's Market

In periods of time when stocks have been rising without fail, investor's can do very well by investing in index funds through Exchange Traded Funds (ETFs) or mutual funds with exposure to certain asset classes. Investors who have owned small-caps through an ETF like the iShares Russell 2000 (NYSE: IWM) have reaped significant profits in the past two years.

However, with small caps trading at rich valuations, now isn't the time to be buying an index fund Instead, times like this point to the importance of stock picking and finding the individual small cap stocks that are hidden gems.

Now is the time to perform thorough and extensive research. As always, I will be on the constant search for the best small cap stocks that have been overlooked by other investors and analysts. It is my job to present you with small cap companies that have attractive valuations that will grow more quickly than their counterparts.

Long-term readers know that I have an impeccable track record picking stocks in the Small Cap Investor Pro email newsletter.

Here are a few of best performing picks:

    * True Religion (Nasdaq: TRLG) +2,216%
    * Investools (Nasdaq: SWIM) +561%
    * Nuance (NAUN) +276%

So with a pullback expected for small caps, now is the opportune time to carefully analyze individual small cap stocks in search of the best opportunities. If a pullback for small caps occurs, you may find your favorite investments trading at a discount, thus presenting a buying opportunity.As always though, with small cap stocks it's always best to focus on the quality and valuation of the individual investment. Through this newsletter, I'll continue search and present to you high quality stocks with rapid growth that are trading at attractive prices.

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