Big Year For Large Caps Expected

Brian Selzer

OCEAN CITY — Over the last two years, our advice has focused a great deal on the strength of equities and the “Great Rotation” out of bonds into stocks. In 2013, we saw this move start to play out in a big way. As stocks surged to new highs and bonds slumped to their worst performance since 1994, investors moved more than $80 billion out of bonds, while putting $160 billion into stocks.

Looking ahead, we anticipate global economic growth to accelerate in 2014 and see equities to continue to outperform bonds and the rotation into stocks to carry forward. However, within this larger theme we see another important rotation that can be a source of opportunity for investors: a move out of highflying small cap stocks into large caps.

In 2013, large cap stocks, represented by the S&P 500, had their best year since 1997, gaining 32.4%. Yet even more impressive was the performance of small cap stocks, with the Russell 2000 gaining 38.8%. Nor was this outperformance limited to just the past year. Since the bear market bottom in March 2009, the Russell 2000 has gained a total of 264%; that compares to 201% for the S&P 500. Historically, the more volatile small caps have led coming out of recessions, sometimes with long periods of outperformance. After years in which small caps have run ahead of large caps, however, we see a potential change in leadership for three reasons: valuations, synchronized global growth and rising interest rates.

The strong performance by small cap stocks in 2013 helped push key valuation metrics above their long-term means. By comparison, large caps are trading near their historical average on a forward P/E basis even after the past year’s robust gains. On a relative basis, the forward P/E spread between the Russell 2000 and the Russell 1000, another proxy for large caps, was 3.3 times in December, which is on the high-end of the historical range. As the Bank of America Merrill Lynch (BofAML) Small Caps Research team notes, in the past a spread this high has generally pointed to underperformance by small caps over the subsequent 12 months.

After years of a subpar recovery, our forecast calls for global economic growth to accelerate from 2.9% in 2013 to 3.6% in 2014. At the same time, stocks more sensitive to growth outside of the U.S. are seeing their earnings estimates being raised. According to Savita Subramanian, Chief U.S. Equity Strategist at BofAML Global Research, the three-month ratio of upward to downward earnings revisions for the most globally exposed stocks is at its highest level in 16 months, while the revisions for purely domestic companies have been deteriorating.

Smaller companies generally rely on borrowing more than larger ones do and benefit more from access to cheap capital. With long-term interest rates expected to rise in 2014, small cap companies are likely to face greater credit constraints than the more cash-rich large caps. In addition, Federal Reserve tapering and higher interest rates are likely to increase volatility in equity markets in 2014, which could affect riskier small cap stocks more than large caps.

Despite rising valuations and the potential for higher rates, we believe there is opportunity for active managers in the small cap space, particularly in the cyclical sectors, as correlations between stocks retreat back toward the long-term average. However, the weight of the evidence suggests that overall, small cap stocks

are likely to lag large caps. Investors looking for ways to play the next phase of this bull market in equities should consider the mega cap multinationals, which look attractively valued and better positioned to benefit from global economic growth.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)

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