Goldman Sachs: High-flying Small-Cap Stocks Will Soon Falter

Friday, 15 Nov 2013 07:31 AM

By Michael Kling

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Small-cap stocks, which have skyrocketed this year, will soon fall back to earth, Goldman Sachs analysts predict.

Performance of the Standard & Poor's 500 and the Dow Jones Industrial Average has been tepid this year compared with the Russell 2000 index of small-cap stocks, which is up an astounding 36 percent the past 12 months.

That's exactly the problem, the Goldman Sachs analysts warn in a note obtained by MarketWatch.

Editor’s Note:
5 Reasons Stocks Will Collapse . . .

The analysts, lead by David Kostin, gave several reasons why they think a slump in Russell 2000 stocks is imminent, MarketWatch reports.

First, the price-earnings ratio (P/E) for the Russell 2000 has increased 25 percent in 2013. It's now higher than the 10-year average in absolute terms as well as compared with the S&P 500.

In addition, the Russell 2000 has historically outperformed the S&P 500 when corporate earnings per share (EPS) are growing, P/E ratios are increasing and the dollar is strengthening.

But, the Goldman Sachs analysts predict, growth of the EPS for the S&P 500 companies will slow from 11 percent in 2013 to 8 percent in 2014.

"The current S&P 500 forward multiple of 15x is in line with our year-end 2014 forecast level," they write in a research note.

Further, while small caps are fueled by domestic growth, interest may shift overseas. The Chinese and eurozone purchasing manager indexes are over 50, pointing to growth.

Plus, leveraged funds have shorted the Russell 2000.

The analysts forecast a below-average return for the index of 6 percent for the next 12 months. Small caps do have several factors in their favor, the analysts say. The Russell 2000 generally is less impacted by interest rate hikes than the S&P 500 is, and GDP growth should remain 3 percent through next year.

The demise of small caps may already by underway. The index is trailing the S&P 500 so far this month, MarketWatch notes.

Researchers at Bank of America Merrill Lynch also warn that small caps may disappoint next year, Barron's reports. Small company stocks sell for a 20 percent premium over large caps, compared with the historical average of 4 percent.

The small cap index reached a valuation of 21 times trailing earnings, excluding negative earnings, which is 31 percent over the historical average.

Such rich valuations, the BofA experts say, mean investors may be disappointed by total returns, Barron's reports.

Small companies, they add, tend to get most of their earnings in the United States, but Europe seems to be recovering and the U.S. housing market, a mainstay for many small firms, may falter due to rising interest rates.

Editor’s Note: 5 Reasons Stocks Will Collapse . . .

Related Stories:

WSJ: Small-Cap Stocks on Fire

Experts: Micro-Cap Stocks Offer Better Value Than Small-Caps Do

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