Tuesday, October 16, 2007

SMIDs: Not Dead Yet

Of late, there has been much talk heralding the death of the SMIDs. Based on the following, such talk is premature.

As the first chart above shows, beginning in the spring of last year the US equity markets have experienced three corrections – two minis (< 10%) and one that briefly exceeded the fabled > 10% level (this summer). Over the course of the three corrections, the SMIDs have trailed the large and mega cap styles by a fair amount leading some to conclude that the SMIDs era of outperformance is over. I say, not so fast.

Without a doubt, the fundamental argument for underperformance is a strong one. SMIDs are largely domestic US companies and, therefore, will suffer the consequences of a weakening US economy to a greater degree than the large and mega cap companies who receive a greater portion of their revenues and profits from the global growth story than do the SMIDs. Adding to this argument is the forecast for a weak US dollar, which helps US export companies, the same large and mega cap group.

While I do not disagree with the fundamental reasoning, the technicals of the SMIDs are only one half as bad. Specifically, the deteriorating relative strength shown in the first chart is fairly clear and makes plain that the quality migration cycle is well underway as money moves from lower to higher quality issues*. However, applying the longer term moving averages principle (see second chart**) argues that whatever problems do and might afflict the SMIDs, it hasn’t shown up in a violation of its longer term mega trend.

Part of the answer for this persistent strength resides in the hedge fund world and the need for alpha via higher risk bets. With liquidity still very high and the pressure to perform always on very high, hedgies have little choice but to find the bets that generate whatever alpha they can get their hands on. Another supportive argument is the fact that valuation of the SMIDs versus the large and mega group is not excessive. P/Es and PEG ratios are right around the large and mega cap rates. Lastly, part of the argument for a SMID underperformance or even negative return rests with weakness in the US dollar. Now, while there is little disagreement re the long term direction of the US dollar (down and dirty), over the very near term the large speculator bets have become so lopsided to the short side (third chart) that what is known as a crowded trade has developed which presents the potential for a counter rally in the dollar over the near term. Such a rally would help allay some of the dollar related fears for the SMIDs.

Investment Strategy Implications

Without question, where you want to be is in the big boys' space. However, there remains many SMID bets that can work and, while the bulk of an investor’s assets belong in the large and mega cap space, investors should not shy away from selective opportunities in the SMIDs.

*Smaller cap = lower quality, large cap = higher quality.
**The small cap ETF, IJR, is illustrated. The same picture is seen using the Mid Cap ETF, MDY.

Note: to view a larger version of the above charts, click on the image.

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