Is the market efficient? Efficiency as in prices reflect all known and relevant market information. By those terms, prices are by definition efficient, which is another way of saying that neither hidden value nor veiled excess lurk in the shadows.
If the market is efficient, then whatever Mr. Market tells us is the start and finish of any investment conversation. One of the ways that Mr. Market talks is by assigning market capitalizations to the various sectors. If the market is truly efficient, then sectors with the largest capitalizations are presumably also the ones with the brighter futures compared with those of lesser values.
But if the market’s efficient, would Mr. Market’s assessment of the morrow in a given sector differ radically across market-cap spectrums?
The question comes up these days when you peruse the world of large-cap stocks relative to their small-cap brethren. In particular, the S&P 500, representing large caps in one corner, and the S&P 600, a proxy for a cross-section of small companies, in the other.
In the large-cap realm of the S&P 500, the financials industry continues to command the lion’s share of the market capitalization. Taking 19.8% of the total S&P 500 market cap, financials enjoy all the hope and faith that Wall Street can muster. Indeed, financials have been at or near the top of the feeding chain for some time. The likes of Citigroup, Bank of America rule the hill here. Never mind that interest rates may go up in the months and years ahead and cut into this sector’s bread and butter. That’s a distant fear at the moment. Instead, the financial behemoths are presumed to be winners come hell or high water, or so Mr. Market suggests.
But Mr. Market is not of one mind when it comes to financials. Indeed, there’s a different perspective over in the small-cap market, where stodgy industrials comfortably lead the market-cap race. Taking an 18.3% share of the S&P 600’s market cap, industrials have been the darlings within the small-cap universe. We’re talking of names like Oshkosh Truck Corp. and Roper Industries, which manufactures various industrial instruments.
On the surface, the two sector leaders seem to be prudent choices. In both the large-cap financials and small-cap industrials, earnings have been advancing nicely. Yet the big-cap financials have the edge in terms of a lower projected valuation. Based on Standard & Poor’s numbers, the expected price-earnings ratio for the financials in the S&P 500 will be 11.3 once 2005 earnings are reported. The comparable p/e for the small-cap industrials will be materially higher at 16.8, based on projected 2005 earnings.
The notion of higher earnings overall is no pie-in-the-sky dream. A survey released today by the National Association for Business Economics gives reason for expecting growth to remain a force for some time in the American economy. “Hiring plans continue to improve, capital spending appears healthy, and profit margins are strong by historical standards,” says Jim Meil, chief economist for the Eaton Corp., via NABE’s survey. Although there are signs that the pace of growth may be slowing, there are no smoking guns that suggest anything like a recession is imminent, the NABE report suggests.
Economic growth, capital spending, and the like, of course, help boost earnings. As such, it’s no wonder that Wall Street expects both large-cap financials and small-cap industrials to report higher earnings by the time the final reports for 2005 go into the history books.
But growth doesn’t mete out its benefits in equal doses. In support of that notion, we cite today’s report from Richard Berner, a Morgan Stanley economist who’s charged with keeping an eye on the United States. “Labor markets have firmed noticeably over the past two years, judging by traditional cyclical metrics such as the unemployment rate and the median duration of unemployment,” he writes. “Together with rising inflation, I think tighter labor markets will soon push up nominal compensation growth in time-honored, cyclical fashion.”
Meanwhile, a number of economists are saying that when April’s payrolls numbers are released early next month, the month will show some progress over March’s slim payroll gains of 110,000. Among the numbers being thrown about by dismal scientists is a gain of 175,000 for April. Hardly a roaring economy, if it comes to pass, but neither is it low enough to dismiss Berner’s worries.
In a world where economic growth is chugging along, but so too is inflation, it doesn’t take much to expect that more interest rate hikes are in the cards. If so, will financials remain the darlings along with industrials?
Already there are reasons to wonder. Although the S&P 500’s financials are expected to have the lower p/e relative to the S&P 600’s industrials, it is the small-cap industrials that are projected to raise earnings by 25% vs. 8% for big-cap financials. On a relative basis as well, the small-cap industrials seem to have the edge as well: the sector’s 25% earnings growth rate predicted for this year is near the top among the S&P 600’s sectors. The S&P 500’s financials’ 8% earnings advance, by contrast, is near the bottom among big-cap projected earnings growth rates.
Mr. Market, once again, will have to prove his efficiency, and dismiss quite a lot of historical baggage in the process.