Trading Desk: Avoid The Market’s Top-Heavy Trap

I just saw a chilling statistic that hammers yet another nail into the coffin of buy-and-hold index fund investing while giving more selective traders a fresh reason to cheer. A real gap has emerged between big and little stocks in terms of valuations.

Believe it or not, “big” here reflects all public companies currently worth $25 billion or more. They dominate the major market benchmarks but are still a tiny minority of the public stocks that investors can actually buy.

And they’re still significantly overvalued even after their recent lurch to the downside. Stocks in this group command an 18X multiple, which is on the rich side even in normal times and precarious in a world where Wall Street is running from rising interest rates.

I wouldn’t buy any stock at 18X simply because it’s already come a long way up. There would need to be more compelling reasons, like a strong defensive moat, a rich dividend or accelerated growth.

The S&P 500 doesn’t really offer anything like that right now. Those stocks are mature, but that means slower growth and more vulnerability to outside disruption. Any hungry little company with vision and a little luck can eat the giants’ lunch.

As it is, these “big” companies account for a full 90% of the S&P 500 by market capitalization. The index as a whole trades at a much more appetizing 15.8X anticipated earnings. Why?

Do all the math and the smallest stocks in the index trade at a steep discount. Maybe they only average 12X earnings. That’s not bubble territory. That’s deep value territory.

Unless there’s a compelling reason to own one of the big companies, I’d rather stick to the small end. Dollar for dollar, they just don’t look as overextended as the giants.

And beyond the S&P 500, there are literally thousands of companies that don’t show up on the index at all. Some are overpriced, don’t get me wrong. But a lot of them aren’t.

Of course small stocks are more obscure. They don’t usually have hundreds of analysts watching their every move like they were Apple (AAPL) or Microsoft (MSFT).  You have to do more work.

You need more conviction. But when you find one, the rewards are that much more extreme.

No pain, no gain. And small stocks are outperforming as a group even in this Fed-induced selling. This is where you want to be.

The index funds can’t reach down this far into the market. You need to be an activist stock picker to find them. That’s why I’m cautious but excited about the future.

It’s about time the ability to pick a good stock outweighed the simple test of size. The big don’t always get bigger. Normally, they’re slow . . . and when they move fast, it’s in the wrong direction.