Experts: With Small Caps Hitting Record Highs, It’s a Case of Buyers Beware

Monday, 25 Feb 2013 08:18 AM

By Dan Weil

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Small cap stocks have been on a tear lately, rising to record highs as they outperform their larger brethren. But many experts say small caps have reached overvalued levels.

The Russell 2000 Index of small stocks reached an all-time peak Tuesday. Since Dec. 1, it has gained 11.5 percent, outdoing the Standard & Poor’s 500 Index, which has climbed 7 percent during the same period.

The difference is even more startling for the long-term. Since January 2000, the Russell 2000 has ascended 85 percent, compared with just 7 percent for the S&P 500, The Wall Street Journal reports.

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Small caps have outperformed large caps for almost 14 years, the longest streak ever, according to Ned Davis Research. If history is any guide, there will be a reversal, the firm says.

Others agree. Small caps are "overvalued on most measures relative to large caps" and thus likely to suffer more in a market decline, Stacy Francis, a New York-based financial adviser, tells The Journal.

Comparing stock prices with per-share earnings and growth rates, William Callahan, a financial adviser in Omaha, Neb., estimates that small caps now trade at an 11 percent premium to large caps.

"You're taking on more risk only to pay a higher price for every dollar of expected profit today," he tells The Journal.

Rob Arnott, chairman of Research Affiliates, tells The Journal that both small caps and large caps offer poor value, as on some fundamental measures small caps look more expensive than large caps and vice versa on others.

Small caps have typically outperformed large caps when the economy is recovering from a recession, according to The Journal.

Fran Kinniry, senior investment strategist at Vanguard Fund Group, tells Barron’s this is just another cycle for small caps. In the late 1990s large caps outperformed, in the early 2000s, small caps were on top, and from 2007 to 2011, large caps led again, he says.

Moreover, looking just at gains in the indices without including dividends is deceiving, Kinniry says. That’s because dividends account for a greater portion of returns for large caps than for small caps.

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