Large-cap stocks look cheap relative to small-cap stocks.
Those who sold stocks during or after the crash and were slow to reinvest as the market rallied might want to use the recent sell-off as a buying opportunity. Over the past year, taxable-bond funds have seen net inflows of about $330 billion while stock funds have lost $10 billion. This would suggest that investors are seeking the safety of bonds. But at the same time, small-cap funds have seen about $12 billion of inflows while large caps have seen about $45 billion in outflows. In this article, we argue that now is a good time to invest in large-cap stocks relative to small-cap stocks and make some suggestions about which exchange-traded funds to use.
Depending on how they are grouped, small-cap stocks make up only around 10% of the U.S. equities market. Thus, they should make up only a small portion of the equities allocation and an even smaller portion of the total portfolio once bonds are included.
Large-cap companies tend to have wider economic moats and greater exposure to faster-growing international markets, and they are more likely to get a lifeline from the federal government. Small-cap companies typically grow at faster rates and stand to benefit from the large cash balances of large-cap companies should merger and acquisition activity pick up. Because they often operate within niche business segments or have just one business line, small caps are less diversified and are more sensitive to economic uncertainty, which results in greater volatility. But with this greater volatility comes the expectation of higher returns. Over the past 10 years, small caps have had a standard deviation of return of 22.2%, compared with 16.6% for large caps. One way to interpret this number is that, in any given year, if we expect small caps to return 8%, there would be a 36% chance of losing money and a 21% chance of losing more than 10%.
Based on Morningstar indexes, over the past 10 years, large-cap stocks have lost 2.7% per year while small caps have gained 4.8% per year. This outperformance of small caps has caused them to look more expensive relative to large caps. On a price/earnings basis, small caps currently trade at about 15.6 times earnings while large caps trade at about 14.1 times earnings. Thus, small caps trade at about an 11% premium to large caps. This is wide by historical standards, as over the past 10 years, small caps have traded at a slight discount to large caps on average. In the midst of the tech bubble, large caps traded at a P/E of 31 times while small caps traded at 16 times. Part of the reason that small caps currently trade at a premium is that analysts expect them to have better earnings growth over the next three to five years. However, we feel that GDP growth is likely to disappoint, which will impact stocks with higher growth expectations more severely than stocks with more muted expectations.
Based on the thesis that small-cap stocks are expensive relative to large-cap stocks, risk-averse investors who are underweighted in stocks might want to put money into large-cap funds, while investors who are overweighted in small-cap stocks might want to reallocate money away from small caps and into large caps. Aggressive or tactical investors might want to place a pairs trade, selling small-cap funds and buying large-cap funds.
As the most-liquid small-cap ETF, iShares Russell 2000 Index
For the large-cap exposure, Vanguard Mega Cap 300 Index
Michael Rawson is an ETF analyst with Morningstar.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.