Small-cap stocks have historically outperformed their large-cap peers only when profit margins are rising. The good news is that margins have been rising and are near record levels. The bad news is that margins are mean reverting ... in plain English, what goes up must come down.
In the last quarter of 2010, profit margins for S&P 500 index members were 8.2%, well above the 15-year average of 6.1%. That may not sound like much, but reverting to the average would reduce profits by a whopping 26%, all else being equal.
As you'd expect in a rising margin environment, small caps have outperformed large caps over the last 12 months. The total return on the iShares S&P SmallCap 600 Index ETF
Buy low, sell high
After that run-up it's no surprise the Russell 2000 Index of small-cap stocks has a P/E ratio of 40.2 times. That's more than twice the S&P 500 index's P/E ratio of 16.7 times. It seems there's an opportunity here to buy large caps low and sell small caps high.
No time for stock picking? One easy way to invest in large-cap stocks is the popular SPDR S&P 500 Index ETF, which has a weighted average market cap of $94 billion and a forward P/E ratio of 13.7 times. The SPDR Dow Jones Industrial Average ETF
Like dividends? Consider the Vanguard High Dividend Yield ETF
Perhaps you think corporate America has a lot more room to boost margins by cutting costs even further. (Nah, me neither.)
But if you expect rising inflation and tepid revenue growth to squeeze margins and pressure profit growth, it's time to think about shifting your portfolio to larger cap stocks.
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Fool contributor Cindy Johnson does not own shares of any security named above. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.