A month ago, I saw an interesting exchange between two money managers who had entered into a bet regarding whether large-company stocks (as represented by Warren Buffett's Berkshire Hathaway) or small-company stocks (Russell 2000) will have better performance in the decade to come.
These types of "bets" are often interesting, as was the case in early 2008 when Buffett himself bet a hedge fund operator that the S&P 500 would beat whatever five hedge funds that operator wanted to collect into a portfolio over the next 10 years. Given that this bet began in early 2008, just before the worst bear market since the Great Depression started, one would think Buffett's position might be in trouble. Au contraire — six years in, Buffett's index was up 43.8% vs. just 12.5% for the hedge funds.
At any rate, while the friendly competition is interesting, the thing that jumped out to me when reading about the small vs. large bet last month was the valuation comparison detailed by the large-company bettor, David Rolfe.
Rolfe writes: "The Russell 2000 Index’s 30% compound return since the beginning of this bull market in March 2009 has made the Russell 2000 significantly overvalued. According to investment manager Leuthold, the Russell 2000 Index’s relative valuation, currently at a 40% normalized P/E premium, hasn’t been this high since 1979. In addition, according to Citi Research, the Russell 2000 P/E, minus the broad market’s P/E, is at 34-year highs."
This relative valuation gap between large-company and small-company stocks is one reason why we weighted SMI's 2014 allocations toward large stocks and away from small ones. Below is a table showing each risk category, SMI's allocation to it for 2014, and the 2014 year-to-date performance of each category's closest benchmark ETF (through last night).
|Category||2014 Allocation||YTD Return|
|Small Growth (IWO)||16%||-5.66%|
|Small Value (IWN)||18%||-1.38%|
|Large Growth (IWF)||22%||0.12%|
|Large Value (IWD)||24%||3.12%|
So the good news is we've had the category allocations pretty much spot-on so far this year. The bad news is Upgrading hasn't been performing well as the market transitions away from last year's momentum winners to those the market largely left behind last year.
This type of rotation is a normal part of the Upgrading process, because the market is constantly evolving. What used to be working isn't anymore, and Upgrading slowly rotates us away from the old winners and toward the new. Of course, Upgrading never looks great during these transition phases. But the alternative is being stuck in funds that don't rotate and going through hot and cold spells anyway as their approach moves in and out of fashion. We feel Upgrading keeps us in the "sweet spot" more than other approaches.