2. Marginally less friendly monetary conditions. As I discussed above, valuation is a necessary, but insufficient, tool for making investment decisions. Investors also need to consider potential catalysts for a change in current performance trends. In the case of small caps, the catalyst for a turn may be the end of quantitative easing and higher real interest rates. In the past, small caps, a more speculative asset class, have been more sensitive to changes in monetary policy than large- or mega-cap names. When monetary conditions ease, small-cap valuations tend to expand. In contrast, when monetary conditions become less accommodative, as is happening today, small-cap multiples tend to contract.
To be sure, none of the above suggests that small caps can’t continue to gain or that investors should sell all their holdings. That said, a combination of stretched valuations and marginally less monetary accommodation implies that small caps may not repeat last year’s outperformance. In short, for investors looking for a place to trim, small caps may be a good place to start.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.
Sources: Bloomberg, BlackRock research