Small to Large: Too Much of a Good Thing May Hit Your Portfolio

NEW YORK (TheStreet) -- Many investors are familiar with the concept of the "small firm effect," or research indicating that smaller companies have outperformed larger companies over time. It is an intuitive concept as smaller firms tend to have higher growth rates than their large-cap counterparts, and earnings growth is what drives stock prices in the long run.

While the "small firm effect" is well documented over long periods of time, we have also observed periods throughout history where large-caps have outperformed. That is to say, the outperformance of small-caps is not a constant; oftentimes, when it reaches an extreme we see a regression to the mean with the large-caps outperforming. We may be entering such a period today.

The chart below illustrates a monthly price ratio of the Russell 2000 Small Cap Index (IWM) to the S&P 500 Large Cap Index (SPY). As a reminder, a rising price ratio means that the numerator (small-caps) is outperforming (up more/down less) the denominator (large-caps). Note how the ratio has been rising for 15 years but recently has started to turn down after failing to break through resistance.

This reversal could very well be in the early stages of an extended period of large-cap outperformance. What would be the driver behind such a move? In a single word: valuation. The 15-year run of outperformance has left small-caps significantly more expensive than large-caps.

According to asset manager GMO's renowned investor Jeremy Grantham, U.S. small-cap stocks are currently the most overvalued asset class in his universe, projected to deliver a real return of -4.9% per year over the next seven years. While U.S. large-cap stocks are also overvalued in their models, Grantham is expecting outperformance over small-caps of 3.2% per year over the next seven years. Grantham's forecasts, while not short-term timing tools, have shown to be quite accurate over the seven-year time horizon.

If they end up being accurate once again in today's market, the implications are significant. Given the 15-year run in small-caps, many investors likely have an outsized weighting to the asset class in their portfolios due to price appreciation alone. Additionally, as most investors suffer from recency bias -- a tendency to chase recent performance -- any new purchases made over the past few years were likely to favor small-caps.

What can an investor do to prepare for the likely reversal in the years to come?

First, a simple rebalancing out of small-caps and into large-caps would bring an investor's portfolio back in line with their target allocations. A more active investor may consider going beyond rebalancing by reducing their target allocation to small-caps until the valuation gap is closed.

A final re-positioning for aggressive long-term investors to consider would be to reduce their exposure to U.S. small-cap stocks and increase their exposure to the "small-caps of the world," emerging market equities through the iShares MSCI Emerging Markets Index (EEM). According to Grantham, emerging-market stocks are projected to deliver a real return of 3.5% per year over the next seven years, or 8.4% higher than their projected return for U.S. small-caps.

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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