Even Midcaps Must Come Down

March 12, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief investment strategist of Omaha, Nebraska-based CLS Investments.


Expensive Valuations

The biggest knocks against midcaps are their valuation ratios. Regardless of which approach to valuation is used, midcaps look expensive. Current valuations compared with peak valuations in the last 10 years are a challenge. Midcaps currently trade at 21 times trailing earnings, and have traded above 20 times earnings for the past eight months.


The only other time in the past 10 years that midcaps have had a P/E over 20 was during one month in 2007. The average valuation over the last 10 years also suggests overvaluation. The average price-to-earnings multiple (P/E) is 17, and the current P/E ratio is 22 percent above the average. Figure 1 shows the current and 10-year averages for three key metrics, including P/E ratio.


Figure 1: Valuation Ratios

Other risk measures tell a similar story of moderately elevated risk. The current price-to-book value is 20 percent above the 10-year average. The price-to-sales ratio is 35 percent over the 10-year average. Comparing midcaps to other asset classes offers no relief.


On average, midcaps have traded at a 9 percent earnings premium to large-caps. The current premium is 22 percent, significantly higher than the average. Book value and sales valuations show similar levels of increased valuations for midcaps relative to other asset classes.


Given the high valuations, midcaps look vulnerable. Each measure consistently suggests moderate overvaluation for midcaps when viewed in comparison with their own history and the performance of other asset classes.


Lagging Fundamentals

Sometimes improvements in valuations reflect an underlying structural advantage in some asset classes. But midcaps show business fundamentals that are generally less attractive than large-caps. According to Morningstar, both business classes are expected to grow at about 10 percent. That number may be optimistic, but the key is growth rates are very similar.


Figure 2: Mid-Cap ETF Performance Vs. Large-Cap And Small-Cap ETFs


The other metrics in Figure 2 measure business quality. Every measurement shows large-cap businesses are considerably more attractive than midcap businesses. Based on the data, midcaps should trade at a discount to large-caps rather than their current premium.



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