Market View: May 2007
Buy Large-cap Stocks; Sell REITs
Small caps and undervalued stocks have usually been the sweet spots of the stock market. Since 1926, large-company stocks have returned about 10.5% annually while small-company stocks have returned about two percentage points more per year, according to Chicago-based Ibbotson Associates. Similarly, undervalued stocks have, over time, performed better than “growth” stocks—although the evidence here is somewhat more controversial. That’s why our portfolios generally tilt towards funds that specialize in stocks of smaller companies and bargain-priced stocks.
But not now. Since 1999, stocks of small companies have beaten stocks of large companies by a huge margin. And ever since tech stocks began their swoon in March of 2000, undervalued stocks have also been stock market darlings.
The upshot: Small-caps, particularly, have gotten very pricey. Based on estimated 2007 earnings, the price-earnings ratio of small caps recently was 9% greater than the P/E of large caps. Small caps normally trade at a discount to large caps and haven't reached such a lofty premium since 1983, according to the Leuthold Group, a Minneapolis-based market research firm. For those with long memories, that marked the end of another multi-year period of small-cap outperformance.
Common sense tells you that small caps shouldn't sell at higher P/Es than large caps. Small companies have fewer product lines, less access to capital markets and less margin for error.
Consequently, we’ve realigned our portfolios. While every portfolio is different, ordinarily we wouldn’t consider it unusual to have 20% or more of a portfolio’s stock money invested in small-cap stock funds. Today, we’re closer to half that weighting in most portfolios. We believe large-caps offer the most attractive sector of the U.S. market.
The case for growth isn’t quite as compelling as the case for large caps. But incrementally, we have moved some assets into stock funds that emphasize growth stocks as opposed to undervalued stocks. We see overweighting large caps as likely to work whether the market goes up or down or sideways from here. The fundamentals support them in a rising market. And in falling markets small caps typically fall more than large caps.
What's more, large caps and small caps have often tended to lead and lag each other for multi-year periods, so once small caps relinquish their lead, they could well to trail for some time. The same goes for growth and value stocks. We think the evidence backs us up: It’s time for large caps and, to a lesser extent, growth stocks, to excel. We never bet the farm, though. Rather, we make modest moves in the directions we think the market’s fundamentals lead us.
Real Estate Investment Trusts
We recently changed our thinking on Real Estate Investment Trusts (REITs) and reduced REIT allocations for clients in our REIT program by approximately 50% on April 18.
In our previous September commentary, we had recommended staying the course. What changed? Compared to stocks and bonds, REIT valuations had become even more bloated after their 300% plus six-year gain.
Another important valuation tool, price versus underlying property value or net asset value (NAV), was not as worrying: REITs appeared slightly undervalued. However since property values had risen steeply (up approximately 150% in four years) and capitalization rates (a measure somewhat comparable to earnings yield) were close to all-time lows, this measure did not inspire much confidence. If property values turned down, REITs appeared to be vulnerable.
The trigger was the sector’s relative performance. After consistently beating almost all other sectors for over a half-decade, REITs began to underperform the broad market—not for a few weeks, but months. So it seemed wise to protect profits and take some of our money off the table.
We invested the proceeds in CDs and convertible funds, depending on individual clients’ circumstances and income needs. Compared to stocks, convertible securities provide some “cushioning” effect in down markets. And if the bull market continues, convertibles will capture a meaningful piece—but not all—of the gain.
