Small or Large Cap?

In 2000, the market cap weighted S&P500 camouflaged the
underlying weakness in the broader market. Investors focused on the indices (primarily S&P500), and as the biggest stocks rallied, they took the indices up with them. Meanwhile, a stealth sell off was being masked by the new highs

Today, the market cap
weighting is once again hiding something significant from investors:
This time, its the fact that the stock market isn’t particularly cheap. The relative cheap prices of the OEX100 (S&P100) is hiding the relative prices of the rest of the index.


This was the subject of a fascinating column by Mark Hulbert in the Sunday Times. A looked at study of Valuation by Market Cap:

"SMALL-CAP stocks are significantly overvalued. In fact, they are
even pricier, on average, than they were in March 2000, just before the
Internet bubble burst. In contrast, the average large-cap stock is
moderately undervalued.

This picture of a highly bifurcated stock market is painted by data from Ford
Equity Research of San Diego, which tracks around 4,500 publicly traded
companies in the United States. Among companies that have been publicly
traded for at least seven years, the firm reports that 55 percent have
higher price-to-earnings ratios today than they did in March 2000. The
bulk of these pricier issues, however, are in the smaller-cap sectors.
Among the very largest companies, the average P/E ratio is now just a
third of what it was seven years ago."

That very much squares with our views on various sectors. This past Summer is when we gave the nod to big caps, on both a technical basis and as a defensive play.

How can the overall P/E of the S&P500 be so misleading? Hulbert’s answer is based on how the index is put together:

"The S.& P. 500
is a capitalization-weighted index, meaning that each company’s
contribution to it is a function of the company’s size. That would not
necessarily skew the average P/E ratio for the index itself, if the
average valuations of both larger and smaller stocks were similar. But
that’s not the situation today, according to Ford Equity Research: the
50 companies in the S.& P. 500 with the smallest market caps have
an average P/E ratio that is much higher than it was seven years ago,
while the ratio for the 50 largest-cap stocks in the index is
significantly lower".

How different? "According to Ford Equity Research, the average P/E ratio among the
50 largest-cap companies is now 19"
— thats about 30% of what it was for the grouo in March 2000. On the other hand, the 50 smallest companies P/E ratio is now 30.7 — 50% higher than it was in 2000.

Let’s revisit that earlier chart: Its clear that the relative relationship between small caps and large caps changed dramatically in August; The ratio looks to be consolidating or softening:


We will have to see if that relationship undergoes a further shift in the next future . . .


Beyond the Bubble, With Small-Cap Stocks
NYTimes,  March 18, 2007

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What's been said:

Discussions found on the web:
  1. Nova Law commented on Mar 19

    The divergence between small and large caps can be most easily seen if one compares the two ETFs SPY (market-cap weighted S&P500) and RSP (equal weight S&P500). RSP is up

    In the SPY, XOM takes up a 3.4% market weight, while the smallest companies are given a .01% weighting. In the RSP, every company contributes .20% to the total index.

    Here’s a graph:

  2. Jdamon commented on Mar 19

    Barry, now this is the type of analysis that I like to see. A nice balanced piece that discusses investing opportunties (large-cap) and areas that may see some further correction (small-cap). I will definitely be discussing this with my broker as I have a higher weighting of small-cap stocks than the average joe (about 20% of portfolio).


  3. mark commented on Mar 19

    what a great opportunity today, sold more than half of my equities into vanguard treasury fund. all of a sudden getting very bearish…will try to liquidate the other half later this afternoon if we get back up there.

  4. Macro Man commented on Mar 19

    Hmmm…if the S&P 500 trailing P/E is 16.8 (per Bloomberg), the top 50 market cap have a P/E of 19, and the bottom 50 have a P/E of thirtysomething…then surely the middle 400 must be absolutely cracking value in comparison with either the mega cap or the small cap cohorts!

  5. lloyd commented on Mar 19

    Bloomberg lists the S&P 600 Smallcap trading at 21.67x trailing earnings and 18x forward earnings. The Russell 2000 is trading at 38x trailing and 23.4x forward! I put ZERO faith in any forward looking earnings estimates since the street is top-down bullish. I don’t see how small & midcaps hold onto gains generated over the last ~6 months if we really slow down.

  6. Steve C commented on Mar 19

    Mark, I may be buying some of what you are selling – although not today. During this corrective period I’m buying only on down days, more on big down days.
    Is this going to be a 7% correction (where we are now), or a 14%, something in between, or even worse? I haven’t been able to find anyone with a 90% track record, or even a 80% track record to tell me.
    So, since I’m overweighted in cash I’m buying the ETFs: DTM, EFV, EZU, and IWS. These are the conservative ETFs that have the highest momentum scores for future gains – at least 3 months out. 40% going to the foreign ones. The IWS is the mid-cap value index which has a P/E not nearly as high as the small cap indices. As expected, these are up sharply today.

  7. james commented on Mar 19

    The Value Line P/E at the peak in 2000 was only about 13. Today it is about 18. The average stock is definitely more expensive now than in 2000. However, the P/E ratio only tells part of the story. The “E” is derived from record high margins that are about 30% above historical average. Assuming long term averages, the SPX is trading at a P/E of 25 and small caps are in looney territory.

  8. Jdamon commented on Mar 19


    I would highly dispute your numbers. No way was the avg. P/E 13 in 2000. No way in the world.

  9. mark commented on Mar 19

    be careful around here steve…most bulls get villified big time.

  10. Adam commented on Mar 19

    Barry, you would do your readers a great service by discussing PE Ratios in terms of P/multi-year moving average of earnings, as urged by Graham some decades ago and Robert Shiller more recently. To use only the last 12 months’ earnings does not smooth out unusually large earnings spikes (like right now) or dips (like in 2002 or so). Using a moving average of earnings, you will note that the S&P 500 is overvalued by historical standards, above the 20x threshold Graham was uncomfortable with. If you agree that this is a useful exercise, perhaps explain to your readers where they can find reliable earnings statistics for years past, such that we can perform these calculations ourselves. I, for one, would be very interested to hear your take.

  11. Larry Nusbaum commented on Mar 20

    Over the last eighty years, small-cap stocks have been the best-performing size category of stocks. I got this data from Professor Ken French’s Web site.
    From 1927 through 2006, an index of large U.S. growth stocks produced an annualized return of 9.3 percent; large U.S. value stocks, by contrast, had a comparable return of 11.5 percent. Among small-cap stocks over the same period, growth stocks returned 9.3 percent, and value stocks returned 14.5 percent –
    Small Cap Value returns from 1927-2004: 14.7%
    Micro Cap returns from 1927-2004: 13.0%
    Large Cap Value returns from 1927-2004 : 11.7%
    Large Cap Growth returns from 1927-2004: 9.5%

  12. james commented on Mar 20


    I didn’t say average – Value Line is an equal weight index…not cap weighted. The Value Line survey P/E is a median one, which is a better measure of the avg stock I would argue. I.E. of the 1700 stocks in the survey, the 850th P/E was about 13 in 2000. This is a fact whether you want to believe it or not. Not surprisingly, the average stock is up HUGE from 2000, while the mega caps that dominate the SPX have gone nowhere.

  13. DavidB commented on Mar 21

    My favorite trade is to buy options and leaps on big cap stocks. I liken it to a synthetic small cap. You get the stability of a big cap with the growth potential of a small cap.

    Food for thought

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