Although we rarely make major calls for investors to exit certain segments of the market or drastically reduce exposure to a specific index or group of companies, one call that we made to our readers and clients beginning in March of 2014 was to reduce exposure to small cap stocks. Our valuation metric (Percent to Target) that tracks the valuation levels of entire indices signaled that the Russell 2000 index looked extremely overvalued at the time. Not only did the small caps look overvalued, but the valuation of the index as a whole was quickly approaching bubble-level territory. Only twice in the past 20 years had the Russell 2000 been overvalued to that extent.
On three separate occasions we suggested to our readers that the large cap space (Russell 1000) was much more attractive from a valuation standpoint than their small cap counterparts (Russell 2000). We also suggested investors consider greatly reducing exposure to small cap companies or exit the space completely. Since the original call in March of 2014, the Russell 1000 has significantly outpaced the Russell 2000 by over 16%.
We gather data on the valuation upside of every company within the Russell 1000 and Russell 2000 indices on an aggregate basis to determine the valuation levels of each index as a whole. When overall valuation levels approach +/-1.5StdDev, it signals that the index is extremely over or undervalued and outside of normal ranges. The Russell 2000 index had been trading near its -1.5 StdDev line for nearly two years and the subsequent tanking of the index has not been surprising.
Our most recent update of valuation levels within both indices shows us that although Large Cap stocks (Russell 1000) still look slightly more attractive than small caps (Russell 2000), small caps are now within the range of normal valuation levels and we are no longer recommending reduced exposure to small cap equities.