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Small Caps Are Now More Expensive Than At The Peak Of The Tech Bubble

Everyone knows that tech stocks are – or at least until investors realized that tax reform is a fiasco for the tech sector, were – the darlings of the market, resulting in the biggest concentration of hedge fund holders with a record number of HFs holding the 5 FAANG stocks; at the same time far fewer are aware that while the tech space trades at less than 50% of its peak “dot com” valuations, it is the small and mid caps that have been the best performing, not to mention most overvalued sectors in recent years.

First, looking at midcaps, an analysis by BofA’s Dan Suziki reveals that despite the small-cap rally in late-November – as Trump tax reform gained momentum – it was the mid-caps that posted the best retums and the most multiple expansion for the month. All size segments saw their valuations expand across all five of the valuation metrics the bank tracks, marking the third consecutive month that the forward P/E rose across small, mid and large. Which is ironic considering the recurring, and wrong, calls that record stock prices are the result of earnings growth and not PE expansion.

Looking at valuation, BofA notes that both small and mid-caps both trade at the 99th percentile of their historical valuation range since 1979 vs. the 89th percentile for large caps.

Despite underperforming the other size segments, small-cap valuations expanded to a new cycle high of 19.3x, the fourth-highest level in data history, and just 3% from the all-time high (19.9x). Putting this in context, Suzuki writes that “small caps are now more expensive than they were at the peak of the Tech Bubble.”

Their premium to large continues to hover at around 4%, below the 6% historical median premium since 1985, while their 2% premium to mid-caps is also below the 4% historical median.

Meanwhile, the forward P/E for the Russell Midcap index expanded the most of all the size segments, climbing to 19.0x from 18.5x — the biggest monthly change since February. With valuations at a two-and-a-half-year high, mid-caps now trade at a 26% premium to their 15.1x historical median forward P/E since 1985. And, relative to the mega caps, mid-caps currently trade at 3% premium compared to a 1% historical median premium.

Here an interesting observation by BofA, as well as some bad news for value investors: the bank calculates that while growth typically trades at a premium vs. Value across most metrics (with P/E-to-Growth being the exception), today’s valuations are cheaper versus history for three of the five metrics (except on P/BV and PEG for both small and mid). And, at 23% for small caps and 24% for mid, Growth’s forward P/E premiums over Value are still below their historical median levels.

Wrapping all of this up, it suggests that while hedge funds may be souring on techs and taking profits due to tax reform or any other reason, their options of which sector to shift to are limited, as both the small and mid-cap sectors have rarely, and in the case of small-caps – never – been more overvalued.

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