In a column in Sunday's New York Times, newsletter guru Mark Hulbert makes the case that small-cap stocks are significantly overvalued, and that large caps are undervalued. His argument is based on expanding price/earnings multiple for small-cap stocks, while the average large-cap P/E is down to one third of what it was seven years ago. This, in part, explains the underperformance of stocks like Home Depot Inc. (NYSE:HD) and Wal-Mart Stores(NYSE:WMT), whose CEOs have taken some heat for their heavy compensation in the midst of a flat stock price. These companies have provided consistent earnings growth, but the multiples have contracted to the point where the stock has remained relatively flat.
But are these companies on the verge of reward, or at least avoiding the downturn that Hulbert seems to be predicting for small-caps? I wonder. The piece does not provide any data on this going back earlier than 2000. In his book The Only Three Questions that Count, Ken Fisher made the case that the price/earnings ratio of the market is not an accurate predictor of whether stocks will move up or down. In fact, stocks seem to move higher when they exhibit high P/E ratios. I wonder if this phenomenon would hold true for the spread in the P/Es between small-caps and large-caps.
Before you go off and dump your small-caps to buy General Electric Co. (NYSE:GE) and Exxon Mobile Corp.(NYSE:XOM), remember this: While small-caps may underperform large-caps as a whole, the predictive value of this for any one stock is almost nonexistent; there will be underperformers and out-performers in both categories. I believe that investors will find the most success with stock picking in small-caps and micro-caps, where research is more likely to pay off (with large-caps, everything is often already factored into the price).