Any Good Deals Out There in the U.S. Equity Market?

April 29, 2016

Given the current market environment, there are no real compelling “buy” opportunities as measured by a variety of valuation metrics. On top of that, economic growth is slow, yields are low, and equity returns are weak. As such, one of the primary conversations we have with clients is around rebalancing, both at the broader asset class as well as between the underlying components of each asset class. In particular, we have recently spent a lot of time discussing the relative valuations of large-cap and small-cap U.S. equities in an effort to identify the more attractive opportunity in today’s market.

In this week’s chart, we examine the P/E ratios of U.S. large-cap and small-cap stocks and compare today’s values to their 20-year averages, removing outliers for when earnings are near zero or negative. The intuition is that the farther today’s P/E ratio is from the long-term average, the more (or less) attractive it is from a valuation standpoint: a reading below the long-term average signals a discounted price, whereas a reading above the long-term average indicates the index is expensive. As seen in the chart, both are near their historical averages, suggesting there isn’t an overly compelling case for either.

How they have gotten to this point over the last 2–3 years, though, is very different. Large-cap companies have slowly returned to this average as a result of investor caution as well as the gradual — but consistent — rise in earnings from 2011 to 2015. Recently though, earnings have slightly fallen for larger companies, which has caused some concern for investors. Small-cap stocks, on the other hand, feature more volatile valuations, with swings in earnings the primary explanation of volatility. In theory, during times of “risk-off” sentiment, large-cap stocks should outperform smaller companies, and vice versa for “risk-on” periods. But with ambiguous market data and valuations so similar to historical averages, investor sentiment is unclear, thus making it extremely difficult to truly identify compelling value in either sleeve of the U.S. equity market.