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TMFAleph1 (95.05)

Bull 'n Bear on AAA Rating, Small-Caps

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April 18, 2011 – Comments (0) | RELATED TICKERS: BRK-B , GS , JPM

The two stories that caught my eye this morning:

- The change in outlook from S&P regarding the US's sovereign rating from stable to negative. This is no surprise; in fact, it was long overdue and I think the market was largely anticipating it. Will the U.S. ever lose its AAA rating? In finance and politics, which are driven by groups of individuals, it is best never to say 'never'. The prospect remains extremely unlikely, given that the U.S. can print its own money and has taxing authority over U.S. businesses and individuals. However, neither of these (overtaxing, or money printing) are good solutions and they would bring with them a new set of problems. The market is understandably concerned; perhaps not so much about the threat of default as regarding the way in which the U.S. government will choose to avoid distress. The solutions are not myriad: It will take some combination of increased taxes and reducing entitlement liabilities.

- The WSJ ran a story on the first page of section C that calls attention to the overpricing in small-cap stocks. According to the article, the ratio of the P/E multiple of small-cap stocks to that of large-caps (1.3) is near the levels of 1983 and 2007 -- both were followed by a period of underperformance by small-caps. The question is not so much whether small-caps can continue outperforming in the near-term (they can), but can they escape the graviational pull of mean reversion in their valuations (they can't). Investors who own small caps must be invested in specific names that they believe are undervalued/ fairly valued. The sub-asset class as a whole is unattractive.

Enjoy your day.

Alex Dumortier

(279 words)

 

 

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