Time to 'have it large'?

True, US stocks are no bargain these days, based on some of the most reliable long-term valuation metrics. However, this is not a barrier to further gains. Monetary conditions are still favourably loose and the economy - both in the US and elsewhere in the developed world - is showing clear signs of improvement.

But for those of us of a bullish bent, what size of US stocks offer the best upside opportunities right now?

Size matters

I recently revisited an interesting bit of research from Fisher Investments, the wealth management company run by the legendary Ken Fisher. Like me, Fisher Investments is bullish on the outlook for US stocks.

This time last year, Miles Standish, head of their UK arm, explained to me the reasons for their optimism and their enthusiasm for mega-cap stocks in particular. You can watch our video at bit.ly/Wjk2Tb.

And having already called the market very successfully, they're still convinced that mega-caps offer great potential right now. By their reckoning, we're now in the mid-to-later "optimism" stage of this cycle (see diagram, below).

Splitting bull markets into four stages, they say that mega caps have tended to do best in the final quarter. Looking over the data, I find that this seems to be right - albeit more for in recent decades.

The chart below shows the annualised return for small caps against mega caps, dividing each bull market into four same-sized periods. For mega caps, I've taken the top 10 per cent of US equities by market value, and for small caps, the bottom 30 per cent by market value.

Small caps are clearly very much the place to be as a new major uptrend begins, and they then keep up their leadership for much of the bull market. However, in the last quarter of the bull market, mega caps have tended to win out, and in every instance since the mid-1980s.

Mega caps have also proved the better bet during bear markets. In exactly three-quarters of bear markets since 1928, mega caps have beaten small caps and by a median of 7 per cent overall.

Time to switch to mega caps?

If you believe the bull market in equities since 2009 may be in its later stages, there's some case for switching your US holdings away from smaller-cap holdings, such as a Russell 2000 index tracker, in favour of a tracker covering the S&P 500 or even the S&P 100. The first thing to establish, therefore, is whether we really are likely to be in the final quarter-stage of this bull market.

I date the bull market as having begun in March 2009. Technically, there was a bear market drop of 20 per cent in the summer/autumn of 2011. So, you could argue that the bull market began in autumn 2011. I treat that shakeout as a 'mid-cycle correction', though, rather than a bear market proper. As such, we are dealing with a single uptrend that began some four-and-a-half years ago.

The median bull markets in the S&P since the 1920s last on average 55 months. So, at 54 months, the current uptrend is indeed getting somewhat long in the tooth. True, there have been much longer runs. These were associated with generalised economic prosperity (the 1920s and 1990s) or with sustained recovery from a long malaise (the 1950s).

While equities have generally had a hard time since 2000, and we are in the recovery stage following the credit crisis, I am sceptical we will have a decade-long bull run this time. US stocks are much dearer than they were coming out of the Great Depression and World War II, something that limits their upside potential in my view. (You can read my detailed analysis of US valuations in Market Tactics from May this year: bit.ly/14A9qCt.)

I would agree that we are in the later stages of the present bull market, rather than only just beginning a multi-year expansion.

If I am right, mega-caps may indeed look like an inviting prospect right now. However, it is worth looking at the conditions existing around the times when the leadership baton has passed from small caps to mega caps.

Over time, the major periods of mega-cap outperformance have tended to follow long, strong runs by small caps. I define long, strong runs here in terms of:

■ Extent of the outperformance by small caps preceding the turn.

■ Duration of that outperformance.

■ Overstretchedness on monthly relative strength index reading.

The first two are self-explanatory. The third - the monthly relative strength index reading (RSI) - is a long-term measure of momentum that is widely used by trend-following hedge funds and others. Broadly speaking, readings above 70 per cent are considered to be high or 'stretched', although this condition can persist for quite some time.

Small caps began their latest run of good form against mega caps around the lows of the credit crunch slump in early 2009. Their peak to date versus mega caps was in early 2011, a mere two years after the move began. The distance travelled in that time was also well short of the historic median, and the peak RSI reading was a long way from overstretched. If mega-cap outperformance really did begin at that point, the 2009-2011 small-cap expansion was surely one of the shortest and feeblest on record.

I do not believe this to be the case, however. Far likelier is that small-cap outperformance has not run its course. Small caps have been strengthening against mega caps since July 2012. I believe there is scope for them to reach new relative all-time highs.

When mega takes over

A second possibility is that both small and mega caps will rise at roughly similar rates, as they have done for extended periods in the past. The late 1950s to mid-1960s were one example of this. So, I remain bullish on both the short- to medium-term outlook for both US small caps and mega caps for the time being.

My momentum model for the S&P 500 - which has outperformed the S&P over the long run - remains firmly in bullish mode, and it gave a fresh near-term buy signal on 30 August.