Return of the Small-Caps?

Small stocks struggled mightily compared to larger stocks in 2014, but Wells Capital’s Jim Paulsen said that signs are pointing toward a small-cap bounce-back.

“For several reasons, however, 2015 may prove to be a good year for small-cap stocks,” Paulsen wrote in a recent research note. “First, in 2014, net flows into small-cap EFT funds trailed large-cap flows by the largest margin of any year since at least 2000! Indeed, small-cap fund flows have been paltry in the last few years leaving many investors significantly underexposed to small-cap stocks. Second, the relative price/earnings (P/E) multiple (based on future one-year mean earnings estimates) for small-cap stocks is now lower than at any other time in this bull market and has declined to slightly below average since 1995. Third, historically, small-cap stocks have done poorly during periods of disinflation and much better during years of re-inflation. We expect the deflation scare of 2014 to give way to a “global economic bounce” this year which should be much more hospitable for small company stocks. Finally, although small-cap stocks have struggled during years when the Fed first initiates tightening, their recent underperformance suggests they may do well despite the Fed beginning to normalize interest rates.”

Paulsen says that deflationary periods tend to cause trouble for smaller stocks. He explains why inflation and size are linked, and talks about his outlook for mildly rising inflation indicators in the US, which he says would be good news for small stocks.