On the surface, this market has done absolutely nothing so far in 2015. The S&P 500 is flat year-to-date.stocks-overvalued

But as always, if you dig below the surface you uncover a lot of interesting things. And what I’ve been digging deeper into is the relative performance of small- and mid-cap stocks.

As I wrote in November 2014, I’ve felt that 2015 could be a year when small caps outperform. Their muted performance in 2014 certainly seems to have set them up for some catch-up performance. And so far this year, they have done well.

The S&P 400 mid-cap index is up by 3.4%, while the S&P 600 small-cap index is up by 2.3%. Both are handily beating the broad market.

I love the performance, and continue to think 2015 will be a year when small companies outperform. But when you look at current valuations as of today, you have to wonder when the big money is going to lock in profits.

Don’t get me wrong – I’m not calling for a market crash or anything that dire. But I am suggesting that this market looks poised for a significant pullback in the 5% to 10% range heading into spring. I think this would be a good thing, and would decrease risk of a bigger “reset” in the second half of the year.

Data from FactSet shows that the forward 12-month P/E ratio for the S&P 500 now sits at 17.0, based on the consensus forward 12-month EPS estimate of $123.03. The market’s average forward P/E over the past five years was 13.7. Over the past 10 years it was 14.1.

S&P-500-forward-12-month-PE-chart

Source: FactSet

There are certainly legitimate reasons why valuations in the broad market are stretched. For one, the energy sector is all out of sorts due to the crash in oil prices. That sector’s current forward P/E of 26.9 is well above its 10-year average of 12.1. And that’s helping to inflate the overall market’s valuation.

But still, over time there have always been factors pushing and pulling the broad market’s valuation. The fact remains that right now valuations are stretched.

The broad market strength can be seen if we move down the market capitalization curve to include mid-caps and small-caps in the discussion. The S&P 400 mid-cap index currently has a forward P/E of 18.5, and the S&P 600 small-cap index has a forward P/E of 19.6. Both are trading at premiums to any time in the last decade.

Why is the market continuing to go up when valuations look stretched? What looks like a good deal in a market where most indexes are trading near the high range of their long-term average valuations?

As always, there is no single answer. Part of the market’s premium valuation right now is simple math – stocks have climbed while forward earnings estimates have come down. That dynamic has increased the numerator (price) and reduced the denominator (earnings), thereby driving the P/E ratio higher.

Part of that earnings decline is due to the drop in oil prices, and part is due to the relative strength in the dollar as compared to the euro.

But there is a balancing factor if we dig into a few details. Analysts expect profit margins to expand further over the course of 2015 by around 10% (in the S&P 500). And they also expect earnings and revenue declines to reverse course in Q3 2015 and climb in Q4 and into 2016.

So given that the market is forward looking, it makes sense that long-term investors aren’t overly concerned about stretched valuations. In many ways, it’s a heck of a lot easier just to hold on through any volatility and let earnings catch up.

But still, I’d like to see a pull-back. I think it would be healthy given where valuations are today, since even a decent pull-back would mean stocks are still trading at or above five- and 10-year average valuations.  I think the market can handle some premium, but not too much.

Bull market rallies don’t end because they get old and tired. They end because of economic contraction and massive negative global events. With neither of the latter appearing imminent right now, it makes sense to stay long stocks for the next couple of years, so long as valuations don’t get out of control.

My advice is to heed the broad market’s current valuation and approach any new investments through an extra-skeptical eye. Average into any stock you want to own. And be prepared to hold it through volatility in the coming months. Then any “reset” in valuations should be viewed as a time to initiate and build up larger positions.

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Published by Wyatt Investment Research at