Mid-cap shares poised to 'catch down'

Tell-tale signs suggest investors are not entirely sold on the idea that second-tier shares can be just as immune to a potential economic slowdown as blue chips.

Where’s that cable drag?

London’s two main stock indices have now been on a tear for about a year, recouping deep losses from the Brexit vote within a month, and going on to notch a string of new records. The most recent was last week, despite sterling coming under renewed pressure from polls showing the Conservative Party’s out-sized lead dwindling.

Any performance gaps between mid-cap shares and blue chips have been fleeting, as anxieties about the FTSE 250’s bigger exposure to a post-Brexit economy ease.  To be sure, economic data have often been ambivalent, but still firm enough to keep investor sentiment upbeat, despite inflationary pressures from weak sterling. And even as these begin to propel the pound higher, the Bank of England’s lack of haste to lift borrowing costs off record lows has also been supportive of shares. Against that advantageous backdrop, the FTSE 250 has outpaced the FTSE 100 so far this year, rising more than 10% up till Friday’s close, against 5% by the flagship index.

Even so, tell-tale signs suggest investors are not entirely sold on the idea that second-tier shares can be just as immune to a potential economic slowdown as blue chips.

For one thing, whilst the FTSE 250 and FTSE 100 posted near-identical gains since 24th June 2016— 23.5% and 22.6% respectively—mid-caps have only been leading since April. That was a step-change month for sterling’s recuperation, with the pound wiping out another 2.4% of Brexit vote losses against the dollar in just a week.  Whilst there’s no agreement on the precise relationship between stronger sterling and FTSE 100 exporter revenues, investors have treated the pound’s comeback as a headwind. Yet it is also clear that blue-chip stocks quickly adapt—the FTSE gained 6.8% between mid-April and the beginning of this week. In other words, the FTSE 100’s unease with sterling’s bounce looks temporary.


Source: Thomson Reuters and City Index

Historical PE lessons

It is even more telling in our view that price/earnings ratios of the two indices have gone out of kilter. Historically, investors have usually been willing to pay more for each pound of aggregate FTSE 250 earnings than for each pound of FTSE 100 earnings. That’s one way of interpreting the fact that the FTSE 250’s PE ratio is usually higher than the FTSE 100’s PE. The normal disparity makes sense. Mid-caps typically slant more towards the ‘growth’ end of the spectrum than the ‘value’ end, with higher risk than blue chips. Since the Brexit vote however, the FTSE 100’s PE has surged above the FTSE 250’s. This has only happened once in a sustained way over the last 23 years: see the graphic below.


Granted, the usual provisos about interpreting PE ratios apply. For one, they can be distorted by stock price disruptions. That means the current elevation of the FTSE 100 PE above the FTSE 250’s should be treated with caution. Similarly, expectations about the return to profitability of commodity sectors are creating additional noise. Annual earnings for FTSE 350 energy and basic materials companies are forecast to grow more than 80% on aggregate, according to Thomson Reuters, way above growth rates seen for other sectors. Such optimism plays havoc with PE ratios. Cyclically adjusted versions of PEs can help smooth such problems. These are less standardised however, and to be honest, fall outside the scope of this article.

Still, the lack of a sustained price return differential between mid-cap and large caps since the Brexit vote jars with the failure of their ratings to revert. Until mid-cap earnings expectations normalise, and whilst the pound faces resurgent pressure, we see a greater chance that the FTSE 250 will ‘catch-down’ with its heavier cousin, than vice versa.

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