MARKET SPECTATOR: Small wonders

As large cap stocks hit huge valuations, investors will be looking for the next place to put their money. Small and micro stocks could be next in line for the rally.

The rally over the last 6-8 months has been led by large cap, sustainable dividend paying stocks. This is hardly surprisingly at all given 1) the low interest rate environment we find ourselves in and 2) with confidence so low following the GFC, if anyone was going to buy stocks it was going to be the blue-chip names over some start up junior miner.

As the world slowly becomes more confident and subsequently risk tolerant money begins to move up the risk curve, which we’re starting to see signs of.

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In the above chart, it shows the performance of large, medium and small-cap stocks over a six month period. We can see that the large and mid-caps basically moved together but it was not until late November/ December when the small caps decided to start catching up, and even then it was mainly the small industrial names.

The difference between the small cap ordinaries index and small industrials is that the small ords includes the small resources names whereas the industrials don’t. The main reason why the industrials are outperforming is because the bulk of them actually have cash flow and may pay dividends compared to junior miners which are unlikely to have either.

So as the rally develops and matures, we’re going to start seeing money flow from defensive, high yielding names up the risk curve to more cyclical, growth oriented companies, which will include small caps and even micro caps down the track. Although they will be last cab off the rank!

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As you can see in the above chart, it’s already happening in the US. Since the US election / fiscal cliff low in mid-November, we’ve seen big underperformance of the S&P 100 versus its smaller peers, which indicates a rotation of money out of the larger caps and towards the more growth oriented small and micro-cap names.

Locally, we’re starting to see signs of money moving toward cyclical names that have lagged significantly over the last few years. Earnings have started to confirm that things aren’t as gloomy as what people are saying too. This week alone, we’ve seen the likes of JB HiFi, Harvey Norman, WorleyParsons, Alumina all rise sharply on earnings reports that were ‘less bad’.