Small Cap Stocks Are At Their Cheapest Compared To Large Caps In More Than 20 Years

After another year of strong market performance, small-cap stocks aren't exactly cheap. Yet according to Bank of America analyst Jill Carey Hall, small caps are cheaper relative to large caps than they have been in more than two decades.

The Numbers: In 2021, Hall said the price-to-earnings ratio of Russell 2000 small cap stocks fell 14% compared to a 5% decline for Russell 1000 large cap stocks.

These earnings multiple contractions were driven by extremely high earnings growth. Heading into 2022, Hall said small cap stocks are now trading at a 5% premium to their average historical forward PE. But small caps are much more attractively valued than large caps, which are trading at a 40% premium to their historical average forward earnings multiple.

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The relative forward PE of the Russell 2000 compared to the Russell 1000 currently stands at 0.75x, its lowest since 2001 and 25% below its long-term average of 1.02x, Hall said. Hall anticipates this relative valuation gap will close over the next decade.

"Our long-term valuation framework suggests that the Russell 2000 could see high single-digit annualized returns over the next decade, vs. low single digit annualized returns for the Russell 1000 (and slightly negative returns for the S&P 500)," Hall said.

Top Sectors: Within the small cap space, Hall said the energy and financial sectors appear to be the most undervalued, while the health care sector ranks as the most overvalued sector.

Looking ahead to the upcoming Federal Reserve tightening cycle, Hall said both small caps and large caps have generated positive returns on average during historical tightening cycles. However, both large and small cap stocks typically experience earnings multiple contraction during periods of rising rates.

Benzinga's Take: If you agree with Hall's take that the next decade will be the decade of small cap stocks, you should consider selling the SPDR S&P 500 ETF Trust SPY and buying the iShares Russell 2000 ETF IWM.