Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: Since bouncing off the June 1 low, small cap and higher beta stocks have outperformed the broader S&P 500. Does this signal a bullish trend that risk is back on in this market?
Stovall: I believe it does. If you think about the fact that since the June 1 bottom, the S&P 500 was up about 14 percent, but the S&P Small Cap 600 and the S&P 500 High Beta index both significantly outperformed the S&P 500. So when you also see that the cyclical sectors are beating the defensive sectors, the implication to me is that investors are thinking maybe this rally has some legs, and as a result, they are more willing—at least for now—to buy into the rally by chasing after the higher beta and higher risk asset classes as well as cap sizes.
EQ: How much of the rise in more speculative and higher risk areas of the market be attributed to investors anticipating more stimulus from global central banks? What are some other factors that may have enticed higher risk appetites?
Stovall: I think early on the two words that really captured the reason for the market’s recovery was “anticipated stimulus.” We have received statements or promises of stimulus from the ECB, and now Wall Street is waiting for an actual implementation of stimulus by the U.S. Fed in the form of QE3. At the same time, I would tend to believe that investors are also looking to six-months-plus down the road and are beginning to believe that they could be seeing a trough in the third quarter and improving results as we head into the new year. So global GDP, eurozone nations GDP, and U.S. sector earnings could all be troughing in the third quarter, but then start recovering as we move into the fourth quarter of this year and into 2013.
EQ: The FOMC is widely expected to announce a third round of quantitative easing tomorrow as a result of this week’s meeting. Have expectations hit a point where anything less would be a major disappointment?
Stovall: I think it would because the market pretty much has said that in order for the U.S. economy to continue to limp along at a half-speed rate of recovery, it needs some stimulus. I think that investors might even be disappointed if they don’t get enough stimulus in the form of maybe $500 billion to $600 billion of QE3, which would be similar to what they got in QE2. Also, they might be expecting some other rabbit to be pulled out of the Fed’s hat that would make them feel as if the stimulus really would work, because the first and second rounds of quantitative easing are questionable as to whether they really provided a meaningful amount of stimulus. So investors are expecting a lot, and at the same time, I would not be surprised if we started to see an attempted profit taking shortly thereafter as investors say, “OK, we got what we expected. Now what do we have to look forward to other than an improving economy, which won’t come around for several months yet?”
EQ: If the Fed does announce QE3 tomorrow, do you see the trend of small caps and high beta stocks outperforming their large cap counterparts for at least the remainder of 2012?
Stovall: It could happen for the remainder of 2012 because we do believe that the S&P 500 will work its way higher as the year progresses, though it probably will experience some bouts of self doubt and bouts of attempted profit taking. However, based on history and technicals, we think that it could move up to the 1500 and even the 1550 level, challenging the all-time highs. But I do think that as we continue to move higher, unless the earnings outlook improves for the smaller cap stocks, I would tend to say their valuations are beginning to look stretched. The P/E on 2012 estimated earnings for the S&P Small Cap 600 is 20, versus 14 for the S&P 500, and that’s even factoring in a 16-percent increase in expected earnings for the small cap stocks versus only a 4-percent increase in earnings for the S&P 500.
Also, when you compare the current P/E to historical trailing P/Es, we find that there’s much greater upside for large caps than for small caps. The differential between current P/Es to the long-term median for large caps is 30 percent, compared to only a 7.5-percent differential between the current PE and the median for small cap stocks.
EQ: Do you anticipate investors cycling back into large cap stocks if we do get QE3 because much of the recent small cap movement higher was based on stimulus speculation?
Stovall: Typically, in the beginning of an economic expansion, small cap stocks do tend to do well as investors anticipate that the recovering economy will benefit the more nimble and leaner-staffed smaller cap companies. But, based on the earnings projections that we have for large and small caps, my feeling is we would have to see more optimistic earnings growth be applied to the smaller cap stocks in order for them to justify, if you will, a much stronger advance in share prices. Share prices could continue to rise as investors have anticipated or hoped that the smaller cap earnings do rise more quickly, but if we don’t get an increase in estimates along the way, then I would tend to say that these gains may be vulnerable to some attempted profit taking down the road.