This blog article is for those of you that appreciate some degree of fundamental analysis, and the chart
below tells a story that is very relevant to our investment models for 2022. This fall we started to see
articles in the financial press addressing two important trends. The first is that the performance of the
S&P 500 is increasingly dominated by a narrowing list of large cap tech stocks – to the point that these
highly liquid tech firms have become the equivalent of comfort food for investors. The second factor is
the extreme disparity in relative valuation between the S&P 500 index and every equity index outside
the S&P 500. Dave Wilson of Bloomberg News captures this well in a segment entitled “Ridiculously
Cheap.” In his report Mr. Wilson published the following chart, which illustrates the average estimated
P/E ratio (one common measure of valuation) of the Mid Cap 400, Small Cap 600, and the MSCI
International Equity indexes combined versus the average estimated P/E of the S&P 500.

As of November 10, 2021

As you can see, the relative valuation of the stocks in non- S&P 500 indexes (including small cap, mid
cap, and international equities) are at historic lows compared to the stocks in the S&P 500, at least
based on average P/E. And the degree of this “discount”, not seen in the last fifteen years, is an event
that raises our eyebrows. While there are many good reasons to believe that large firms provide steady
predictable growth and deserve a prominent weighting in any portfolio, one must stop to appreciate the
opportunity smaller more focused companies may provide during an expansion of the real economy.
When we talk about inflation, we are talking about economic expansion. When we talk about Fed
tapering, we are talking about pulling back on the price supports that are provided most directly to the
largest companies. The valuation comparison of the S&P 500 to international equities is more complex,
but the economic expansion is a global event yet core international companies trade at substantially
lower multiples. In view of all of this, it makes sense to us to evaluate this valuation gap and rotate
more assets into small cap, mid cap, and international opportunities.

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