However, this year has demonstrated how the relationship is more complex. Yes, a stronger dollar has proved a headwind for large-cap company earnings, but small caps have actually been underperforming, according to Bloomberg data. Part of the reason has to do with why the dollar is appreciating: rising real (after-inflation) interest rates. As data accessible via Bloomberg show, U.S. real 10-year rates are up roughly 60 basis points (0.6 percent) since the end of January.
This, in turn, is having an impact on small-cap valuations, based on Bloomberg data. Through October, S&P 500 Index multiples actually rose a bit. However, the price-to-earnings ratio on the Russell 2000 Index of small-cap stocks contracted by around 2.5 percent. It should be noted that this is consistent with history.
Looking forward, to the extent we see a gradual rise in real rates, higher real rates are likely to keep small-cap valuations under pressure. Finally, according to Bloomberg data, large- and mega-cap names also have the advantage of cheaper valuations relative to the broader market.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.