WSJ Asks, “Are Small Caps Too Pricey?”……I Answer and Offer A Way To Play

by Dan April 18, 2011 9:18 am • Commentary

I for one spend a lot of time focusing on large cap names, largely for the same reason most institutional traders do, liquidity.    While there are plenty of great opportunities to invest in, or short small cap stocks, I generally gravitate to the larger ones for what appears to be be greater transparency, and longer operational track records.  Makes decent sense that if a company enjoys success (or perceived future success) then eventually investors will buy the stock and as Mr. Pitt says “the stock will rise HIGH”, and thus move up in market cap.  So there is a bit of snobbishness to the whole “small cap moniker”, but we here at RiskReversal don’t discriminate.

Yesterday on the, they asked the question in their Abreast of the Market column”Are Small Caps Too Pricey?

Some Quick Excerpts, WSJ from April 18, 2011:

-The Russell 2000 Index, which comprises about 2,000 stocks with small market capitalizations, is within about 2% of a record closing high.

-it looks destined to reach well before larger peers such as the Dow Jones Industrial Average and the Standard & Poor’s 500-stock index, which are off their record highs by 13% and 16%, respectively.

-Small companies now command the widest premium over large-cap stocks in at least a generation, based on the ratio of price to earnings.

-The Russell 2000 is trading at almost 18 times one-year forward forecast earnings, a record high, according to Bank of America Merrill Lynch

-That P/E ratio is about 1.3 times the P/E of the market’s largest 200 companies as measured by Russell Indexes, according to Lori Calvasina, director of small-cap equity strategy at Credit Suisse, the highest since at least 1979, when her data begin.  The valuation gap has approached this level only twice before, in 1983 and 2007. After both instances, small-cap stocks vastly underperformed their larger brethren, Ms. Calvasina says.

-The rally from the March 2009 bottom has seen the Russell 2000 rise 143%, topping the Dow’s 89% gain and the S&P’s 95% rise.

-“With the U.S. growing at only 3% and global GDP [growth] more like 4.2%, small caps are going to be hamstrung” by their relative lack of exposure to emerging markets, says Mr. DeSanctis of BofA Merrill Lynch.

-Investors are expecting small caps to show 19% earnings growth for the January-to-March quarter just concluded, compared with 13% to 15% for the S&P 500, he says. But he thinks that small-cap forecast is unlikely to be achieved at a 3% economic growth rate.

Technically there is the divergence that you would expect between large and small cap stock indexes, the SPX is up about 26% since the QE rally started Sept. 1, 2010 and the Russell is up about 40%. Chart Below shows the out 6month out-performance of the IWM iShares Russe 200o Index ETF (Red line) vs the SPY (Yellow line).

6 month IWM vs SPY LiveVol Chart

MY VIEW: While many of the things currently aiding the performance of small cap stocks relative to their larger cap brethren at this stage of the economic recovery are likely to persist, at some point in the near future it makes sense to me that regardless of some of those characteristics that we will see an unusually high level of correlation among risk assets when the market eventually goes back and tests last months lows in the SPX of ~1250.

– I am looking for this to occur sometime in the next few weeks as we get deeper into earnings and Q2/Q3 guidance will have hints of an economic slowdown, coupled with the end of QE2….the markets should start quickly to anticipate this and based on last weeks market action I am beginning to gain more confidence in this outlook.

-IWM should retest previous support of 78, the level in which it bottomed in mid March. The fact that the Russell is being perceived rich to other market cap groups will only add fuel to the fire when stocks start to move back south in earnest.


IWM (stock Ref 83.51) Buy May 80 / 78 Put Spread for ~.40

-Buy May 80 Put for .95

-Sell May 78 Put at .55

Break-Even on May Expiration:

Upside: Stock btwn 79.60 and 80 lose up to .40,

Worst Case: above 80 lose all .40 (or less than 1/2 % of the underlying)

Downside: Stock btwn 79.60 and 78 can make up to 1.60 or 4x your money.

Best Case: stock below 78 (down ~6.5%) and you make all 1.60

TRADE RATIONALE:  A $2 wide spread on an $83 stock seems tight, I want to put the odds of success in may favor without committing to much capital/premium.  While many would suggest that a ~6% move lower in a month is not that very likely, I maintain a high level of skepticism (stubbornness!) about the markets ability to power higher in the face of what I see as a whole host of risks looming over the continued pace of the recovery.  I want to make a low premium bet with a high payout relationship if I am right.  If volatility in the market picks up just a little this spread should carry fairly well, as the 80 strike Put is not that far out of the money and is a ~25 delta option.