December Charts of Interest: A Small-Cap Resurgence?

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This year’s final charts of interest offers an updated look at market leadership, valuations and inflation. We explore the modest resurgence in small-cap stocks, the climbing valuations of large-cap stocks and even the rising cost of celebrating the Twelve Days of Christmas.

Before we start, I want wish those of you who celebrate the holidays a merry Christmas, a happy Hanukkah and a joyful Kwanzaa. The AAII offices will be closed from December 24, 2024, until January 2, 2025. As such, there will be no Investor Update sent out next week.

Interest Rate Cuts Have Led to a Rotation in Leadership

The Federal Reserve’s interest rate cuts have been good for both small- and large-cap stocks (but not mega-cap stocks). Small-cap stocks have outperformed the Magnificent Seven technology stocks ever since Fed chairman Jerome Powell set the stage for cuts in July, as have mid-cap stocks and the equal-weighted S&P 500 index.

Part of this reflects the greater reliance of smaller companies on outside capital. Valuations may also play a role. Robert Carey and Peter Leonteos of First Trust Portfolios echo what we’ve been pointing out for a while: “Valuations for the S&P 500 Equal Weight, S&P SmallCap 600 and S&P MidCap 400 [indexes] remain more attractive than those of the Bloomberg Magnificent 7 and broader S&P 500 [indexes].” Carey and Leonteos point out that, as of December 11, 2024, the price-earnings (P/E) ratios for each of the indexes in this chart were as follows: Bloomberg Magnificent 7 (42.43); S&P 500 (25.52); S&P 500 Equal Weight (19.32); S&P MidCap 400 (18.54); and S&P SmallCap 600 (18.52).

Small-Cap Stocks Remain Historically Cheap Relative to Large-Caps

The Leuthold Group calculates small-cap stocks as trading nearly 30% below their historical median relative price-earnings ratio. This is a distortion we’ve been pointing out for a while.

While we continue to expect a reversion back toward the historical norms, the timing remains uncertain. Small-cap stocks will outperform when this does finally occur.

A Widening Gap in Return on Equity

The difference in return on equity (ROE)—the percentage profit earned relative to shareholders’ interest in the company—between the best and worst 25% of companies “has widened dramatically over the last 15 years and rarely been bigger” notes Denise Chisholm, Fidelity Investments’ director of quantitative market strategy. Chisholm added, “Relative earnings have been incredibly strong, but multiples appreciated, not depreciated as typically seen historically. This sets us up for a situation not seen before—if relative earnings for the [quality] factor deteriorate, the starting points have never been this expensive.”

Return on equity is just one way to measure quality. There are several other metrics including accruals, gross profits to assets, change in liabilities relative to assets, etc. AAII’s A+ Investor Quality Grade looks at up to eight different measures.

The Rule of 20 Suggests Stock Valuations Are Getting Pricey

Stock prices and valuations are inversely related—all else being equal—so it’s not surprising to see the S&P 500 getting pricey lately. The Rule of 20, which says the market is fairly valued when the consumer price index’s (CPI) year-over-year growth and the S&P 500’s price-earnings ratio add up to 20, “suggests stocks have been getting increasingly expensive,” opined Charles Schwab chief investment strategist Liz Ann Sonders last week.

Market Forecasts Were Way Off, Again

Still not convinced that everyone is using cracked crystal balls? Look at the chart below.

In posting the chart last week, Charlie Bilello of wealth management firm Creative Planning pointed out that “at 6,090, the S&P 500 is now 690 points above the highest 2024 year-end price target from Wall Street strategists and 25% above the average target (4,861).”

Even with yesterday’s drop, the large-cap index remains well above the price targets. At least the market strategists underestimated instead of overestimated where the S&P 500 would be at now.

Not So Sweet: Cocoa Prices Are at Record Highs

Severe droughts in Ghana and Ivory Coast have caused the price of cocoa to soar to record highs. The International Cocoa Organization says there is also dry weather being reported in Ecuador, which ranks third in cocoa production behind the two African countries.

As a fellow chocolate lover, I am sorry to have to share this news.

Christmas Is Going to Cost You 5.4% More This Year

Each year, PNC Financial Services calculates how much it would cost to buy everything listed in the classic holiday song "The Twelve Days of Christmas." The bank cautions that “true loves should hang on for deer life because overall, the 12 gifts that comprise the PNC [Christmas price index] increased to a tree-topping $49,263.”

Want to really show your love and buy all 364 gifts instead? Doing so will set you back $209,272. The full list is below.