Will 2019 Be The Year Of Small Caps (In Europe)?

I admit it—I was stunned by January’s turnaround in market performance.

It seemed logical to consider a more defensive approach. And if someone had asked me if it was appropriate to over-weight small-cap equities, I wouldn’t have had the guts to say yes after being shell-shocked by the VIX spiking to 36 in late December.

But small caps have been off to an incredible start in 2019.

What’s Easy? Slipping into Old Patterns

With the current global backdrop, a U.S. allocation is one of the easiest to create a compelling narrative around. The Brexit uncertainty in Europe, for example, is enough to buttress this narrative. The Russell 2000 Index has started 2019 off strongly, delivering a double-digit return in January. There is little question that investors will notice.

But it’s important to remember that small-cap companies tend to be businesses with long-term goals, and U.S. growth is currently late in its cycle. So, while it may be possible to squeeze further positive performance from small caps, there isn’t much in the way of a valuation cushion, should conditions deteriorate.

  • The lower risk of U.S. small caps should lead to the Russell 2000 Index having a higher forward P/E multiple—a factor that is not in dispute. The real question is, given the balance of risks, how much higher should the multiple be than, say, that of the WisdomTree Europe SmallCap Dividend Index? What we see in figure 1 is something on the order of 50%.
  • The forward P/E ratios of the WisdomTree Europe SmallCap Dividend Index and the MSCI Europe Index have been quite similar, with the WisdomTree Index having the current advantage.

Figure 1: European Small Caps Offer a Massive Discount over U.S. Small Caps

European Small Caps Discount over U.S. Small Caps

European Small Caps Are Impossible to Ignore

Since 2013, the WisdomTree Europe SmallCap Dividend Index has opened up a dramatic performance gap over the MSCI Europe Index. This illustrates an important point, especially since we recognize that when investors look beyond the U.S., they often look only at large caps. The key explanations of this opportunity for small caps in Europe are:

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