If the mantra> for real estate is "location, location, location," then the motto for the current market rally is "risk, risk, risk."
For definitive proof, forget about the spikes in emerging market equities or junk bonds and just take a look at small-cap stocks. These little guys (their average market cap comes to less than $750 million, according to Russell Indexes) are on a rocket ride. Indeed, the small-cap benchmark Russell 2000 index is up nearly 64% since its March 9 low. During the same period, the S&P 500 has risen an amazing -- but less impressive -- 47% and the Dow Jones Industrial Average has climbed 41%.
There are sound historical reasons for the outsized outperformance of small caps, but the question now is whether there is any value left in these pint-sized shares. With such a remarkable run, putting new money to work in small caps now could just be a way of committing the cardinal sin of chasing returns.
Steve Scruggs, portfolio manager at Queens Road Small Cap Value Fund (QRSVX),
But now, the portfolio manager is taking profits rather than making new commitments. In February Scruggs says he was fully invested in equities; today he's sitting on a whopping 25% in cash.
"It's amazing how short memories are," he says. "We're seeing valuations worse than in 2006 when we were still oblivious to what was ahead of us. Small caps are now priced for a sharp V-shaped recovery and that is just not the case."
Small-cap investors aren t just being foolish, mind you. If past is prologue then there's ample reason to pour money into smaller stocks, one of which is this asset class's history of phenomenal outperformance during the early stages of bull markets.
In the eight bull markets between 1960 to 2008 small caps greatly outpaced the S&P 500 in the incipient rally, according to Fidelity's Market Analysis, Research and Education group. Sure, they might start a bit slow, but nine months into a new bull market small caps produced a total return of 44% vs. 32% for the broader market. And 12 months in, the return came to 51% versus 34% for the S&P.
True, with the forward price/earnings ratio on the Russell 2000 now at 48, according to Birinyi Associates, small caps are at valuations not seen since near the top of the last bull market in 2006-07. On the other hand, if you look at trailing P/E (which stands at 15 excluding negative earnings, according to Russell), the asset class is not nearly so pricey, says Bryan Place, founder of Place Financial Advisors in Manlius, N.Y.
"If you look at trailing earnings small caps are still below their 20-year average, so I think there is still a little value to be had," says Place. However, that doesn't mean investors should jump on the momentum train, the advisor says. "I would probably still be overweight small caps relative to mid or large caps at this point," he says. "But I'd buy the index and be very careful about my entry point. Don't buy into a big rally."
Michael Church, president of Addison Capital Partners, a Yardley, Pa.-based investment management company, is even more wary of small caps right now. He says the recent returns are nothing more than a return of pure speculation. "It's not just small caps," Church says. "You've seen all sub-$10 stocks go bananas."
At this point small caps are priced for economic recovery and not much more, says Church. Putting new money to work in small caps now is a bet that growth comes back with a "vengeance," something neither he -- nor economists' forecasts -- see transpiring.
So if small caps are broadly overbought right now, what's a small-cap investor to do? Adriana Posada , senior portfolio manager at American Beacon Small Cap Value Fund (AVPAX),
"For small caps as a whole, valuations are not compelling," Posada says. "But throughout this entire rally, lower-quality companies have outperformed higher-quality companies, leaving lots of high-quality individual names with attractive valuations." Higher-quality names have strong balance sheets, meaning little or no debt and strong cash positions. Tech stocks, for example, are a sector where Posada is looking for such attributes.
The catch? Small-cap investments require a lot of patient legwork to find -- and even then their value won't be unlocked "until the economic picture gets much better," Posada says.