At a time when every asset class seems expensive, the U.S. small-cap space is attracting special warnings.
"Since 2009, it's been a really good run for small-cap performance," said Steven DeSanctis, head of small-cap strategy at BofA Merrill Lynch Global Research. "Just about every stock has been picked over, and so there are just not a lot of bargains out there."
Investors inclined to agree may consider reducing exposure to smaller U.S. stocks, even if they might struggle to find attractively priced ways of redeploying the proceeds.
Small-cap investing has been a pretty reliable path to outsized gains over the course of the bull market. This is common of market recoveries, as investors return to riskier assets.
The extraordinary losses suffered by smaller stocks in the financial crisis and ensuing recession made for a low base on which to start a tremendous small-cap rally.
Even as the broader market registered one of history's longer bull runs, the small-cap universe outshone.
As measured by the Russell 2000 index, small caps have gained about 270 per cent since the market bottomed out in March, 2009. Meanwhile, the S&P 500 index, representing the U.S. large-cap space, rose by about 210 per cent.
He said he's also keeping a close eye on the Canadian energy sector, particularly lower-cost small- and mid-cap companies. "They are fantastic future opportunities if we can feel comfortable with oil prices."
Small-cap outperformance has, in fact, been one of the defining characteristics of the U.S. market over the last decade, but last year was an exception.
In 2014, the market's favour abruptly shifted to the relative safety of larger, more stable companies, which propped up their earnings and their valuations by showering money on shareholders.
Dividends and share buybacks among S&P 500 companies together amounted to almost $904-billion (U.S.) in 2014, which marked the highest total on record and a 16-per-cent increase over the previous year, according to S&P Dow Jones Indices.
Then, last fall saw another reversal of investor preference.
U.S. economic strength and the rising U.S. dollar improved the outlook for small caps disproportionately. Smaller companies tend to export less and thus have reduced exposure to the competitive disadvantages inflicted by a strong dollar.
Small-cap investors pounced, trading up the Russell 2000 by 23 per cent in the six months up to mid-April, while the large-cap benchmark rose by 13 per cent.
At the same time, however, forecasted profits for small-cap stocks plunged. In September, estimated 2015 earnings growth for the stocks included in the S&P SmallCap 600 was 22 per cent, but by March that fell to 8 per cent, Mr. DeSanctis said in a presentation at a recent small-cap summit hosted by FTSE and Russell Indexes in New York.
"Outside of a recessionary period, to see estimates fall this dramatically is something worth noting," he said. The dropoff in profit forecasts is still sizable even when the considerable effect of the energy sector downturn is excluded.
"Slower earnings growth with higher valuations isn't exactly a great scenario," Mr. DeSanctis said.
The average Russell 2000 stock now trades at about 19 times forward earnings, a level that history predicts will be followed by a small decline in the index over the next 12 months, with the probability of small-cap outperformance at less than 50 per cent.
Small-cap valuations have become prohibitive for some value investors.
"We're banging our heads against the wall because we just haven't been able to find companies that are cheap enough and that fit our criteria," said Ed Lugo, portfolio manager for Franklin Global Small-Mid Cap Fund at Franklin Templeton Investments.
The fund's U.S. weighting has declined to about 25 per cent, compared with a weighting of more than 60 per cent in the fund's benchmark.
The money freed up by limiting exposure to the United States has mostly found a home in Europe, Mr. Lugo said. "We're still finding names there, it's still the cheapest spot."