Small caps trade at a premium, but can you justify this premium?

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Nov. 20 2020, Updated 2:21 p.m. ET

Today, small-cap indices are trading at a relatively expensive level versus large-cap companies. When real rates were negative, this premium was more justified. However, this premium will be harder to justify as real rates continue to rise, unless small-cap companies can generate significantly faster earnings growth. This suggests to us some compression in the valuation of small caps relative to large caps over the next couple years. It also suggests that larger firms are likely to do better in an environment of higher real-interest rates. One way to access larger US firms is through the iShares S&P 100 ETF (OEF).

Market Realist – The graph above shows the historical price-to-earnings or PE multiple of small caps (IWM) relative to mega caps and large caps (OEF). The long-term average stands at 1.3x. In other words, on average, small caps have traded at a premium of 33% over mega and large caps since 1997.

At the moment, though, the ratio stands at 1.5x. It has been above the long-term mean for over five years. A mean reversion could take the premium down. A rise in interest rates could easily cause this reversion.

Read on to the next part of this series to learn one drawback of investing in equities (SPY)(IVV) compared to bonds (BND).

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