Quick Look:
- Small Caps Set For Outperformance: Valuation gaps suggest that small caps could significantly outperform large caps in the coming years.
- Tech Dominance Waning: Big tech’s elevated valuations may give way to small-cap opportunities.
- Valuation Disparities: S&P 500’s forward P/E is 21.3 vs. S&P 600’s 13.9, indicating potential for small caps.
Investors might be undervaluing an entire segment of the stock market, which could lead to a decade of remarkable outperformance. While the S&P 500 has set new all-time highs in 2024, not all stocks have participated equally in the current bull market. Over the past few years, extensive tech stocks have driven the stock market’s surge. This trend has recently accelerated as innovations among the most prominent companies, particularly in artificial intelligence (AI), have increased stock prices.
The Big Tech Bubble and Valuation Concerns
The market anticipates substantial earnings growth from these tech giants in the coming years, leading to elevated valuations. However, one crucial indicator suggests that the dominance of big tech may soon wane, offering investors a lucrative opportunity in an entirely different group of stocks. The price-to-earnings (P/E) ratio, a commonly used valuation metric, tells us how much we pay per dollar of earnings for a given stock. A significant valuation gap becomes evident when we compare the market segments’ forward P/E ratios based on expected earnings.
A Huge Valuation Gap That Can’t Be Ignored
The forward P/E ratio gap between the large-cap S&P 500 and small-cap S&P 600 indexes is among the widest since the start of the century. The S&P 500’s forward P/E stands at 21.3, while the S&P 600’s is at just 13.9. The last time this gap was so pronounced was just before the dot-com recession 2001. Although this isn’t a prediction of an impending recession or significant market downturn, it does suggest that smaller companies might drive the next market upswing. History has shown that while the S&P 500 struggled in the early 2000s, small caps soared, and we might see a repeat performance soon.
The Massive Outperformance of Small Caps
Over the long term, small caps have historically outperformed large caps, though this outperformance occurs in cycles. The last time the valuation gap between large-cap and small-cap stocks was this wide, the S&P 600 generated significant returns for investors. From 2001 to 2005, the S&P 600 delivered a total return of 66.7%, significantly outperforming its large-cap counterpart.
During the same period, the S&P 500 managed only a 2.8% total return, highlighting the disparity in performance. The S&P 600 achieved a compound annual growth rate of 10.8%, reflecting its strong performance. This historical context underscores the potential opportunities in small-cap stocks when the valuation gap widens. Investors may find substantial returns in small-cap stocks during similar market conditions. Even through the Great Recession, small caps outperformed, with the S&P 600 returning 109.2% versus the S&P 500’s 15.1%.
How to Invest in Today’s Market
Several factors have caused small-cap stocks to lag behind larger companies in recent years. Higher interest rates have pressured small caps that rely heavily on debt for growth. Additionally, the availability of a 5% risk-free return from Treasury bonds has led investors to discount future earnings, further disadvantaging small caps. Furthermore, recession fears have prompted many investors to favour more prominent, stable companies. However, small caps might soon see relief from high interest rates. The Federal Open Market Committee plans to cut interest rates at least once this year, and if inflation continues to improve, rates could drop even faster. With recession fears waning, it might be the perfect time to invest in small-cap stocks.
Simple Strategies for Small-Cap Investments
Investors can research individual small-cap companies to find the best opportunities, as these stocks are less followed by analysts and institutional investors, presenting a chance to outperform the market. Alternatively, investing in small-cap index funds offers a more straightforward approach. The SPDR Portfolio S&P 600 Small Cap ETF (SPSM) is a good option, as it closely tracks the benchmark index with a low expense ratio of 0.03%. Another option is the iShares Russell 2000 ETF (IWM), which tracks the broader Russell 2000 index. Though it includes more growth stocks that haven’t yet become profitable, it’s favoured by some big-name investors. The Avantis U.S. Small Cap Value ETF (AVUV) might be ideal for those seeking a blend of passive and active investing. It uses profitability and valuation criteria to narrow its investments, keeping fees low at 0.25%.
A Balanced Portfolio Approach
While large-cap stocks should still be in any diversified portfolio, now might be an excellent time to tilt some weight toward small caps. Whether you choose individual stocks or index funds, the current market conditions and historical trends suggest that small caps are well-positioned for a period of significant outperformance. As always, thorough research and a balanced investment strategy are crucial to maximizing this promising opportunity.
