the Standard & Poor’s 500 It has set new record highs after new highs in 2024, but not all stocks are participating in the current period. bull market.
Over the past few years, big tech stocks have been the driving force behind the stock market’s surge in value. This trend has accelerated recently as innovations among the largest companies using artificial intelligence have driven their stock prices higher.
The market expects these innovators to deliver massive earnings growth over the next few years, and investors have raised their valuations as a result.
But there is one indicator that Big Tech’s dominance may be about to shift: Investors may find a great investment opportunity in a completely different set of stocks.
A huge valuation gap that cannot be ignored.
One of the most widely used valuation metrics in investing is the price-to-earnings (P/E) ratio. This ratio tells you how much you would pay for each dollar of earnings for a given stock. For example, if a company earned $1 per share in earnings over the past year and its stock price is $20, its P/E ratio is 20.
Since stocks are valued based on future expectations, looking at the forward price-to-earnings ratio can be a better indicator of whether a stock is fairly priced. The forward price-to-earnings ratio uses management or analysts’ earnings expectations over the next year to calculate the ratio, rather than past earnings.
Looking at stocks as a group and comparing their value to historical averages can help determine whether the market as a whole is overvalued or undervalued. Comparing the price-to-earnings ratio of one market sector to another can also help identify investment opportunities.
Currently, the gap between the forward price-to-earnings ratios of the S&P 500 for large-cap and small-cap companies S&P 600 The index remains as wide as it has been since the turn of the century. As of this writing, the S&P 500’s forward price-to-earnings multiple is 21.3, while the S&P 600’s forward price-to-earnings multiple is just 13.9. The last time the spread exceeded seven levels was shortly before the dot-com bust in 2001, according to Yardeni Research.
I’m not suggesting that we’re headed for another recession or major market decline in the near future, but it seems increasingly likely that the next phase of the market rally will be driven by smaller companies.
While the S&P 500 struggled to make any gains in the early 2000s, small-cap stocks surged. History may be repeating itself.
Massive Outperformance of Small Cap Companies
Over the very long term, small-cap companies historically outperform large-cap companies. But this outperformance comes in cycles. Small-cap companies lag behind in some periods and then significantly outperform in others.
The last time the valuation gap between large-cap and small-cap stocks was this wide, the S&P 600 continued to generate outsized returns for investors compared to its large-cap peers.
From the beginning of 2001 through 2005, the S&P 600 returned a total of 66.7%, or a compound annual growth rate of 10.8%. By comparison, the S&P 500 returned a total of only 2.8% over the same five-year period.
During 2010, the year of the Great Recession, small-cap companies continued to perform better. The S&P 600 returned 109.2% in total versus 15.1% for the S&P 500.
How to invest in the market today
There are several reasons why small-cap stocks have lagged behind larger companies in recent history. One reason is that interest rates have risen in recent years, putting pressure on small companies that rely heavily on debt for growth.
Moreover, investors will discount the value of future earnings if they can get a 5% risk-free yield on Treasuries. This is a double whammy for small-cap companies. Moreover, recession fears over the past two years have led more investors to favor larger, more stable companies.
But small businesses could benefit from some relief from higher interest rates. The Federal Open Market Committee expects at least one rate cut this year. And after two months of better-than-expected inflation data, the market believes the Fed could cut rates faster. Recession fears have also eased over the past year.
This may be a good time to invest in small-cap stocks. You can research individual companies to find the best opportunities among smaller stocks. These companies are not as widely followed — fewer analysts and institutional investors are buying and selling the stock — meaning there is a greater chance of outperforming the overall market.
But the simplest way to buy small stocks is to use an index fund. You can buy small stocks. SPDR Portfolio S&P 600 Small Cap ETF (NYSEMKT: SPSM)This ETF does a good job of closely tracking the benchmark with an expense ratio of just 0.03%.
Another option is an index fund that tracks the Russell 2000, which is often used as a benchmark for small-cap stocks. This fund doesn’t have any profitability requirements like the S&P 600, so it includes a much larger number of growth stocks that haven’t yet made a profit.
While the S&P 600 has historically outperformed the Russell 2000, some big-name companies Billionaires Buy Russell 2000 Index Funds Like the iShares Russell 2000 ETF (NYSEMKT: IWM).
My personal favorite way to invest in small cap stocks is to: Avantis US Small Cap Value ETF (NYSEMKT: AVUV)Technically an active fund, this fund uses a variety of profitability and valuation criteria to narrow down the universe of small-cap stocks and weigh investments across 774 stocks. The result is a mostly passive portfolio that still keeps fees low at just 0.25%.
While there is still a place for large-cap companies in any portfolio, investors may want to consider using one of the ETFs mentioned above to weight their weight toward small-cap companies in today’s market.
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The stock market is doing something unprecedented since 2000. And history says it will happen next. Originally posted by The Motley Fool