Why the P/E Super Cycle May Prolong Small-Cap Outperformance
In Crying wolf, Abnormal Returns notes the continuing drumbeat in favor of mega-cap stocks. The post notes that the pundits have been predicting that small-cap outperformance would wane for several years now. Still, the small-caps continue to do better than their larger brethren. Why?
One reason may, as we have pointed out, have to do with long-term cyclical trends in the stock market. During these cycles, the P/E ratio in the market is either expanding or contracting. Stock markets fluctuate over the time periods due to changes in earnings (the “E”) but the underlying trend is the overwhelming influence. In a recent SafeHaven post, John Mauldin includes the following chart and explanation:
Note something on this chart. Most of us start the secular bear market of the 1970s as actually beginning in 1966. The Dow then made an historical high in 1972, only to retreat to 600, run back to 1,000, fall to 750, run up and then run down, etc…
The key graph on the preceding chart is the P/E ratio at the bottom. It just kept dropping over time. Prices went all over the board, but the P/E ratio went from the upper right to the lower left on the chart. A classic secular cycle. So, could we see a repeat? Another market high on the way to lower valuations in the future? Absolutely! Why would anyone think we are any smarter now than we were then?
Likewise, during the 1982-2000 expansion cycle, the P/E ratio allowed stock prices to advance much further than the underlying earnings growth would indicate. These P/E expansions and contractions have historically lasted for 15-20 years and in each contraction the market P/E has fallen to single-digit levels.
So what does this have to do with small-cap outperformance? If small-caps boast higher P/Es than large-caps, don’t they have further to fall?
Not necessarily. The P/E cycles are applied to overall markets. And within those markets, the vast majority of the market capitalization is dominated by the largest firms. In the US, more than 80 per cent of total market cap is held in the S&P 500 large-cap names. In order for the overall market to trade at a single-digit multiple, the large-cap names must trade in the single digits on average. If the large-cap names traded at even as low a multiple as 12.5x, all of the other stocks must have a multiple of zero in order for the average to be in single digits. However, if the average large-cap traded at a multiple of 9x, the remaining 20 per cent could trade at 14x (more than a 50 per cent premium to large-cap) and still give the overall market a single-digit multiple.
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