Is now the right time to switch the emphasis of your clients’ equities portfolios to large-cap stocks?

Some investment advisors are already taking such measures. Their reasoning is that small-cap stocks worldwide have climbed so strongly that they have become too expensive and have left large-caps far behind. In addition, steady dividends make large-caps attractive — and candidates to catch up to small-caps in price.

How you deal with this strategy depends on your view of the current cyclical bull market. If you are confident the bull has more time to run, you will tend to ignore this advice. That’s because small-caps lead bull markets.

However, if you suspect the bull’s run will soon end, changing emphasis to large-caps would be prudent.

The reasoning goes back to studies of the behaviour of groups of stocks of differing size. The first codification was by American researchers Roger Ibbotson and Rex Sinquefield. They showed that micro-caps and small-caps rise by more than large-caps in bull markets — and drop by more in bear markets. Mid-caps usually perform in between these extremes.

The large/small interaction appears in every stock market. In Britain, for example, small-caps have gained by 15.6% a year since 1955 while the broad market gained by 12.8% per year.

In Canada, the S&P/TSX small-cap index has climbed by 122% to a recent monthend 754 from its early 2009 low of 340. In the same time span, the S&P/TSX 60 index climbed by 59%, to 779 from 490.

This is a prime example of high volatility matching high risk. In the small-cap sector, earnings are highly volatile. Despite that, earnings prospects for Canadian small-caps are stronger now than for the broad market.

S&P/TSX small-cap index earnings peaked at $11.8 billion ($18, when adjusted to the index) in 2006, then fell to a loss of $8.3 billion (minus $42) in 2009 before starting to show a profit again last May after 17 months of losses. Since then, earnings have varied between $5 and $16 as adjusted to the index, and recently were $2.2 billion ($11).

A projection of the trend since May 2010 suggests that earnings could rise as high as $20 this year — a possible doubling from recent levels.

Large-caps, being less volatile, also have less potential for earnings growth vs small-caps. Earnings on the large-cap S&P/TSX 60 index peaked at $55.50 in December 2008, then dropped as low as $25 in September 2009 before recently rising to $43. Projections for this index suggests a rise in earnings this year to as high as $48-$50.

There is a new S&P/TSX index that is even more large-cap than the S&P/TSX 60 index, but it’s too new to offer earnings projections. The S&P/TSX mega-cap index, launched in December 2010, consists of the 25 largest and most liquid stocks trading on the Toronto Stock Exchange.

In January, the S&P/TSX mega-cap index had earnings of $44.7 billion — or 56% of the broad-market S&P/TSX composite index. The S&P/TSX 60 index represents a wider slice of the market — 81% of S&P/TSX composite index’s earnings. The S&P/TSX small-cap index has earnings equal to less than 3% of S&P/TSX composite index’s earnings.

The dividend records for all sizes of stock indices are flat.

The S&P/TSX 60 index’s dividend dropped to $17.52, adjusted to the index, in the autumn of 2009 from almost $22 in mid-2008. Since then, the index’s payment has changed little, standing slightly above $18 recently.

Similarly, the S&P/TSX small-cap index’s dividend dropped to about $17 in August 2009 from $34 in the autumn of 2006. Since then, it has moved as high as $18 but has lately slipped back closer to $17 — higher than the index’s earnings.

With the rise in stock prices, dividends have become more expensive. The S&P/TSX 60 index’s yield has dropped to 2.3% from almost 4% at the 2009 market crash. In the same period, the S&P/TSX small-cap index’s yield has dropped to 2.3% from almost 7%. IE