There’s no doubt the stock market has behaved much differently after the election than it did in the first half of the year. Riskier, formerly dormant small cap stocks awoke in a big way -- surging 18% in a little over a month.
The question is, can that powerful move continue in the new year? Or have these stocks gotten too far ahead of themselves? Many investors are hesitant to enter the space because they feel the gains are already baked in. But our work suggests there still could be a ways to go.
Look at this ratio chart. It shows how there are times when small caps (as represented by the Russell 2000 Index) lag large caps (as represented by the S&P 500), and there are times when they lead. Right now, they’re leading. But they still have more room to run on a relative basis before they reach exuberant levels.
How about valuations? There’s no doubt they’re somewhat stretched all over the market. The S&P 500 is trading at 21.1 times trailing earnings, compared to an average since 2012 of 17.2 (I use that more recent period because it encompasses the low interest rate environment we’ve been in, a key factor propping up valuations). That’s a 23% premium to the average.
Small caps trade at a higher P/E, 47.4 times trailing earnings. But that represents a premium of only 19.9% to the post-2012 average -- meaning today’s valuations aren’t wildly abnormal. You can also see in this chart that they remain well below what we saw as recently as 2013-2014.
Moreover, small cap earnings are expected to grow $11.74 per share in the fourth quarter, up 9.3% from the same quarter last year. That’s almost twice the 5.3% growth rate expected from the S&P 500 Index. That argues for the small caps to trade at a higher premium than their larger cap brethren.
Lastly, that’s not even considering all the proposed policy moves out of Washington, such as infrastructure buildouts, less regulation for small businesses, and lower corporate tax rates. Those forces should all help more inwardly focused companies like small caps.
Putting it all together, there’s no question this niche of stocks has done very well in a short period. A temporary mean reversion could occur, and naturally, small cap stocks are generally more volatile than large caps. But we haven’t reached the ‘irrational exuberance’ stage -- and that’s why we should still see more upside in 2017 given all the catalysts this space has.
Even better: We’ll soon have a new way to help you profit from surging small cap stocks. Stay tuned to this space for more details. Or click here now to get on the VIP list to ensure you get one of the very first invitations to join this exciting new service at a special discounted rate.
