MARKETS SPECTATOR: Cometh the mid-caps

The rally since mid-2012 has been widespread with most developed markets throughout the world experiencing strong performance.

In Australia, we have been one of the better performers, highlighted by a flurry of funds towards the blue-chip, high sustainable yield end of the market. The degree of this fund flow has never been seen before, underpinned by a record low in cash interest rates of 3 per cent.

With income-needing investors given little choice, the high dividend-paying stocks like the banks and Telstra, just to name a few, have been on a tear with some of the banks even pushing into record territory.

Unsurprisingly, this strong performance at the big end of town has attracted the attention of the brokers, with downgrades flowing through thick and fast, premised on stocks now trading above broker valuations and target prices.

While the big end of town will remain well supported by the yield argument for some time yet, many professionals are starting to question the ability of the blue-chips to push meaningfully higher from here.

While a rising tide tends to lift all ships, the most recent rally has created a big performance gap between large-caps and the smaller end of the market. The word 'rotation' is being bandied about frequently now and we’ve already witnessed investors starting to look elsewhere for opportunities. Recently, the most obvious has been people shifting up the risk curve and looking in the small to mid-cap space for decent dividend yielding stocks.

The first chart below shows by how much the S&P/ASX 100 index has outperformed the S&P/ASX Small Industrials over the last 12 months. However, in the second chart, we can see that since the beginning of 2013 the small industrials index has started to claw its way back and actually finds itself slightly ahead on a year-to-date basis. 

Click to enlarge

Source: Iress

Click to enlarge

Source: Iress

The volatility and fear witnessed during the last five years sapped the market of all confidence, hence the reason there are still so many doubters.

Midway through last year, when this rally began, many investors really didn’t want to move back into equities. It was a classic case of ‘once bitten, twice shy'. But with investors given no choice in terms of earning a decent yield, they went for the biggest, high yielding safe stocks they knew – the banks.

Now, with confidence starting to return, we’re witnessing the beginning of a move up the risk scale as investors start looking elsewhere for equity opportunities. As a bull market develops and confidence builds, it is perfectly normal for participants to start looking for stocks that are yet to move, or have rallied less.

Right now is looking like the opportune time to start looking into some of the sectors that have lagged, most specifically the smaller end of the market where valuations are nowhere near as stretched. It’s only a matter of time before the performance gap between big and small begins to close.