One of the biggest equity market surprises so far this year has been the underperformance of US and European large-cap stocks compared with their small-cap counterparts, says Andrew Garthwaite, equity strategist at Credit Suisse.
He says this makes little sense, given that the high level of market volatility – which has favoured large-caps – is unlikely to fall meaningfully until 2009.
He also says widening credit spreads have usually been accompanied by big-cap outperformance as they have higher credit ratings than small-caps. Lending conditions and business confidence are deteriorating more for small-cap companies than for big-caps, he says.
On a valuation basis, big-cap trades on a 15 per cent consensus forward 12-month price/earnings discount to small-cap in the US, and a 7 per cent discount in Europe (15 per cent adjusting for different sector composition), Mr Garthwaite says. Typically big-cap warrants a 6 per cent premium in the US and 3 per cent in Europe.
“What can justify the current relative outperformance of small-cap?” he asks. “The only reason we can find is the sharp steepening of the yield curve, with small-cap tending to outperform when the yield curve is steepening and steeper than average. However, the yield curve has been a poor predictor this decade – for example, small-cap outperformed when the yield curve was flattening sharply from mid-2003.”