Is it a frenzy or a healthy catch-up for small-cap and emerging-market stks. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary Equity markets have continued to edge up this year. The greatest action appears to be with the smaller-cap and more volatile international-emerging markets. Both of these asset classes have risen dramatically over the past three years relative to the rest of the broader markets. Are we witnessing a buying panic or a healthy catch-up in prices to the broader averages? We are inclined to believe that the rise in U.S. small-capitalization stocks has gone beyond the point warranted by valuations and that the class has experienced a minor mania. Emerging markets, on the other hand, are playing a bigger game of catch-up to the rest of the world, and still possess a certain level of value.

Review and outlook

The equity markets continue to edge up despite rising interest rates and continued uncertainty in the oil markets. Since the beginning of the year, the S&P 500 has risen by 3.5%, with much of the gain coming in telecom and energy stocks, which are up 11.7% and 8.2%, respectively. Likewise, international equities, as measured by the EAFE index, have risen by 5.5%, thanks to both a weaker dollar and reasonable returns from overseas markets. The real action, however, has come in the smaller capitalization markets, including the U.S. small-cap market and the overseas emerging markets, where year-to-date returns are around 10%.

The S&P 500 had a good week, but the large-cap gauge continues to trail other parts of the equity market. After a brief respite last year, small-cap stocks have rallied sharply this year. International equities, particularly emerging markets, also have outpaced domestic large-cap stocks. Whenever an asset class outperforms the broader markets for more than 12 months, market strategists begin to suggest that we are in the midst of an irrational mania. There may, however, be a more rational reason for this outperformance. Assets classes can produce stupendous returns not because they are racing ahead, but because they are catching up, or - to use market jargon - because they are "reverting to the mean." We would argue that recent small cap-stock performance may be closer to a mania, while the healthy numbers posted by international equities may reflect something more like mean reversion.

For the week, the U.S. stock market, as measured by the S&P 500, gained a slim 0.2%. The increase was led by financials and energy companies, which gained 1.4% and 1% respectively. The Russell 2000 small-cap index rose 0.8%, bringing year-to-date gains to 9.5%. International equities rebounded from a poor week to add 1.7%. Most of that came from price appreciation in Japan, which rose by 4.0% for the week. But Japan wasn't the only place overseas that rallied last week. Emerging Markets also increased in value by 1.0%. Year to date, emerging markets are up over 11%. Price increases are a good thing - but are we seeing too much of a good thing?

Too Much Joy?

As a dour Connecticut Yankee brought up under a code that treats excess and exuberance with tremendous caution, high asset returns make me nervous. Over the last three years, there has been no shortage of joy when it comes to the stock market. For the three years ending 24 February 2006, U.S. large-cap equities were up, on an annualized basis, by 17.8%. In the big scheme, however, this asset class has provided comparatively skimpy returns. Small caps were up 28.7% per annum, and international equities were up 28.2% per annum. Emerging markets top them all, with a per-annum return of more than 43%.

Selected three-year returnsThrough 24 February 2006 |image1|Source: FactSet (S&P 500, Russell 2000, MSCI EAFE, and MSCI Emerging Markets)

So now that assets prices have risen by so much, do they have much more room to grow? From a certain perspective, these increases should not be totally surprising. Three years ago the economy and corporate earnings started to rise out of the recession. Fears of a ruinous Japanese-style deflation in the U.S. and abroad were subsiding. The past, however, is a poor fortune teller. To get a handle on what could be, we need to look at valuations and earnings growth trends. |image2|

A value buyer would look at this chart and conclude that the greatest potential for future price appreciation lies with the cheapest asset. By this measure, emerging markets offer the greatest potential for return followed by European stocks. U.S. large caps offer only fair-to-middling value. On the expensive side of the ledger and, hence the assets to avoid, lie the Japanese equities and U.S. small caps.

But wait, wait you may say: this value-based view of the world is the world of the cynic who knows only the price of what he buys. These more expensive assets, like U.S. small caps, are selling at higher prices compared to their current earnings because they have the potential to grow their earnings faster.

Good point. It's worth looking at the earnings growth for each of these asset classes. We find it most interesting to look at growth relative to a trend line. Forecasting earnings is never easy. Over time, however, they do tend to follow longer-term trends. Specifically, corporate earnings should grow at about the same rate as the economy or GDP. If earnings are growing at way above trend line rates, it's logical to assume that, at some point, they are going to decelerate or decline. If earnings are well below trend line, there is room to grow on the upside.

There is both good and bad news around this point. In most markets, we see earnings growing over the short term. Four of the five markets we have listed above, however, show earnings that are above trend line: U.S. large cap and small cap, Europe, and emerging markets. Japan is a different story. Though Japan has seen strong growth recently, it is well below its respective longer-term trend line growth. This is because Japan went through some very difficult times in 1990s and is only over the last few years getting its financial house in order.

|image3| It's worth consolidating into one table what we believe can help us to distinguish between whether the returns we have seen so far represent a mania or reversion to the mean. In a mania, there is nothing to be said that would seem to favor an asset class. The asset rises despite an expensive valuation and above-trend earnings. Assets that have merely earned an extraordinary return because they were cheap to begin with or have realized a pent-up level of earnings growth have earned their return for legitimate reasons.

Based on these criteria, U.S. small caps would appear to be candidates for the "mania" designation. Japan, emerging markets, and Europe suffer from one negative, but they each have an offsetting positive. And, although U.S. large cap's earnings growth is above trend line, the stocks are at least trading at fair valuations.

|image4| This relatively simplistic approach is far from a be-all-and-end-all tool for determining asset allocations. Over the short run, the good earnings growth that we anticipate here and abroad could very well allow all of these assets to produce positive returns over the near term. Over the longer term, however, these factors should tend to dominate an asset's return, and they help explain why we would be inclined to overweight international equities at the expense of U.S. small caps. -FWR

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Review & Outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.