Time for Small-Cap Stocks?
by James Paulsen, Chief Investment Strategist, Wells Capital Management
Small-capitalization stocks underperformed significantly in 2014 and relative to their larger brethren, the S&P 500 Index, have only managed to be market performers since early 2010. Understandably, many investors have recently become frustrated moving portfolio allocations away from small company stocks.
For several reasons, however, 2015 may prove to be a good year for small-cap stocks. First, in 2014, net flows into small-cap EFT funds trailed large-cap flows by the largest margin of any year since at least 2000! Indeed, small-cap fund flows have been paltry in the last few years leaving many investors significantly underexposed to small-cap stocks. Second, the relative price/earnings (P/E) multiple (based on future one-year mean earnings estimates) for small-cap stocks is now lower than at any other time in this bull market and has declined to slightly below average since 1995. Third, historically, small-cap stocks have done poorly during periods of disinflation and much better during years of re-inflation. We expect the deflation scare of 2014 to give way to a “global economic bounce” this year which should be much more hospitable for small company stocks. Finally, although small-cap stocks have struggled during years when the Fed first initiates tightening, their recent underperformance suggests they may do well despite the Fed beginning to normalize interest rates.
Pessimistic sentiment favors small-cap stocks As shown in Chart 1, since early 2011, the relative performance of small-cap stocks has been volatile and disappointing. Both in 2011 and again last year, small-cap stocks underperformed signifi cantly. Chart 2 illustrates how this diffi cult period of performance has shaped investor sentiment. It shows net fund fl ows into large-capitalization ETFs less fund fl ows into small-cap ETFs. Fund fl ows tend to follow performance and refl ect investor expectations or sentiment toward an asset class.
Not only did small-cap fund fl ows trail large-cap fl ows in 2014 by the largest amount since at least 2000, but fund flows have been noticeably biased toward large-cap stocks for the last four years! This refl ects diminishing expectations surrounding small-cap stocks and bearish sentiment which has increased the likelihood of a positive surprise. More importantly, after several years of disappointment, many investors are now probably underexposed to this asset class and would need to boost allocations should performance improve.
Read/Download the complete report below:
Copyright © Wells Capital Management
