Chart of the Week - Small Caps vs Big Tech Valuations
Divided They Stand: There are two groups — deeply divided. Once walking a common path, they now stand in starkly polarizing realities.
Foreign influences, mainstream media, fluctuating economic policy, and structural changes to society have only served to feed this division.
We are of course talking about the valuation gap between small caps and big tech.
This week’s chart shows the Equity Risk Premium [ERP] (the required or expected return of equities over and above the risk-free-rate to compensate for taking on equity risk).
Specifically, my version of it takes the inverse of the PE10 (i.e. a more stable and signal-rich version of the earnings yield) and subtracts the 10-year treasury yield adjusted for the longer-term rate of CPI inflation.
The key thing to focus on is the higher this indicator is, the more attractive it is to own stocks (vs bonds).
For example, check out where it got to in 08/09. And conversely, the lower it is, the riskier it is to own stocks vs bonds (given the lack of compensation for taking on equity risk). For example, see where it got to at the peak of the dot com bubble in 2000.
Knowing that then, we can now interpret where things currently sit. The ERP for big tech is basically zero… so you have to be very confident in the growth and technological innovation/disruption/commercialization story to own tech stocks vs bonds at that point.
Conversely, the small caps ERP — while not as outright attractive as it got to in 2020 or 2009, is still decent vs history and trading at a material spread relative to the same for tech stocks.
Of course the perma-bull optimists will tell you that all is as it should be — investors are rightly confident on tech stocks, and rightly pessimistic on small caps, and therefore you actually need a bigger risk premium to buy losing small caps vs winning tech stocks.
They may also tell you that the tech stock ERP went negative on-and-off throughout the dot com boom, so you can just ignore it and keep yolo-ing into QQQ because there’s room for it go further and valuations don’t matter. And they may be right on both accounts.
But evidence-based investors will look at this chart, consider the data, and at least “have a hmmm” about the relative risk vs reward going forward.
Key point: On the ERP; small caps are reasonable, tech stocks are extreme expensive.
$iShares Russell 2000 ETF(IWM)$ $Invesco QQQ Trust-ETF(QQQ)$ $Technology Select Sector SPDR Fund(XLK)$ $ARK Innovation ETF(ARKK)$ $iShares S&P SmallCap 600 ETF(IJR)$ $Vanguard Small-Cap ETF(VB)$
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https://twitter.com/topdowncharts/status/1729257527895052628
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