Overall equity market volatility, poor breadth and a poor performance from the retail sector all warn of tactical trouble ahead for U.S. small cap stocks. Longer-term measures of risk are also flashing red.
In the chart above we show the difference between our proxies for the small and large cap equity risk premiums, defined as the earnings yield less the long-term Treasury yield for each asset class. This measure is still historically high, signaling that investors are poorly compensated for taking risk in small cap equities. Thus, the onus is on small cap profits to grow at a more robust pace than large cap earnings to justify such thin risk premia. While the latest NFIB survey of the small business sector showed that expected sales have jumped, this may be coming at the expense of profitability. The number of firms reporting profit improvement is sinking anew, and our relative small/large cap profit margin proxy has dropped sharply. The implication of sagging profits is that investors are likely to demand a higher risk premium for investing in small caps, a scenario consistent with additional share price underperformance.
Bottom Line? Our U.S. equity strategists recommend a large cap bias.