Big Time: An Update on Our U.S. Large Cap Bias

Key Points

  • For tactical investors, we recommend a neutral weight to U.S. equities; but a bias therein toward large cap stocks.

  • "Beta bounce" has been like clockwork during this bull market.

  • Most secular trends point to large cap

    outperformance; but

    there are risks to the story.

Having recently upgraded our view on developed international markets (hat tip to Jeffrey Kleintop), we are now recommending investors keep their allocations to all three major equity asset classes—U.S., developed international and emerging markets—in line with strategic targets. We are maintaining our bias toward large capitalization (cap) stocks, within an otherwise neutral U.S. equity allocation. Today's report is an update on my thinking around the cap call.

Secular and cyclical trends

I like to think about markets in both a cyclical and secular framework. From a cyclical perspective, small cap stocks have made several impressive runs at sustainable leadership—and could continue to do so, especially if tax reform gains traction (they are likely bigger beneficiaries). But I think the secular winds are blowing in favor of large caps.

Cyclically, small caps are no longer trading at a trailing P/E premium to large caps, courtesy of recent strong large cap performance—especially within the technology sector. But on forward (full year 2017) estimates, small caps' P/E remains at a premium.

"Beta bounce"

The Leuthold Group does some of the best work on market valuations and cap biases, and I've been a student of their work for more than three decades. They recently highlighted small caps' "beta effect," in which more than all of small caps' historic outperformance has been earned during the first year of bull markets, as you can see in the chart below.

Small cap excess performance by market phase

Source: The Leuthold Group. 1945-June 30, 2017. *Annualized spread, small cap minus large cap total returns.

In fact, the pattern has unfolded nearly perfectly during the current bull market. The "beta bounce" kicked in right at the March 2009 low, driving the Russell 2000 up 98% over the subsequent year (versus +72% for the S&P 500). While small caps eventually moved to a much higher "relative" peak by 2011, those excess returns evaporated by the onset of the 26% decline in 2015-2016.

Following that cyclical bear market, another powerful 12 month "beta bounce" kicked in off the February 2016 low. This pattern is one of several cyclical factors which drive the small cap leadership cycle; alongside interest rates, the yield spread, sector momentum, relative valuations, relative technical conditions, economic growth, government spending and the U.S. dollar. According to Leuthold, the "beta bounce" has been one of the more consistent of these factors.