Can the Might of Mean Reversion Send Small Caps Higher?

Our research team published a very simple Chart for The Curious earlier this month comparing the relative size of small cap vs large-cap stocks. While naïve, the implication was striking. Based on history, the difference between large and small cap stocks indicates that recent gains by small caps vs. large caps may have much further to run.

As documented in our research, we believe that asset bloat in index funds and speculative ETFs that focus on large cap, loss-making firms, has caused this anomaly. In this paper we intend to:

  1. Extend on The Low Cost of High Quality which showed there is a speculative cohort of small caps that are as financially weak today and more expensive than they were at the peak of the internet bubble!
  2. Show how a reversion to the long term averages of “large cap vs. small cap” could generate large gains for small cap investors[1]
  3. Offer investors a portfolio from our Small Cap Model that we believe may represent a generational opportunity to pay historically low prices for some of the highest quality Small Caps – a painfully obvious alternative to “speculation investing” in our view

History suggests that the market bubble today is so dangerous and the opportunity to buy high-quality stocks at lower prices so obvious that keeping things simple is in the best interests of our readers. We would rather be roughly correct than precisely wrong to borrow from one of Buffett’s quips.

The chart below shows the market cap of Small Cap divided by the market cap of Large Cap Firms.

  1. Small Cap stocks need to rise 27% to get back to their average weight vs. large cap stocks[2]
  1. Small Cap stocks need to rise 47% to get back to where they went post the crash!2


Are Large Caps Losing Touch with Reality?

Our research team has written about Buffett’s valuation metric, which scales Market Cap to GDP, repeatedly over the years. Most recently, we published a Chart For The Curious showing that markets were at frightening valuations. We have documented that, while useless for timing markets, this metric has a potent history of predicting future returns over a long time horizon.

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[1] Relative gains, that is to say, small caps could rise a great deal vs. large caps or large caps could decline sharply and small caps could decline by less

[2] Assuming Large Cap Stocks don’t move; Large Caps could collapse and Small Caps don’t change….but you’d still want to own some Small Caps!!

[3] XLF up 6.7% vs. SPY up 0.5%


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