Is It Time to Bet on Small Caps? Analysts Share Insights On The Valuation Gap Versus Large Caps

The relative value of small-cap stocks compared to that of large-cap stocks is trading at its lowest point in over two decades.

As the chart below shows, the price ratio between the iShares Russell 2000 ETF IWM and the SPDR S&P 500 ETF Trust SPY is at its lowest level since November 2001, and has decreased by more than a third in the last year and a half.

Chart: iShares Russell 2000 ETF (IWM) vs. SPDR S&P 500 ETF Trust (SPY)

Changing Dynamics in Small-cap Valuations

George Bonne, an equity research analyst at MSCI Inc. MSCI, recently provided valuable insights regarding the underperformance of small-cap stocks when compared to their large-cap counterparts.

According to Bonne’s analysis, over the past 15 to 20 years, small-cap stocks have generally exhibited higher price-to-earnings (P/E) ratios than large- and mid-cap stocks. Conversely, they have been more attractively priced in terms of price-to-book (P/B) ratios.

However, a notable shift occurred in late 2021 when small-cap stocks began to display lower forward P/E ratios compared to large-cap stocks. This means that they have started to screen relatively more attractive than large cap, on a P/E basis.

Additionally, the valuation gap between the two indexes, when measured by P/B ratios, has currently reached its widest point since March 2003.

This raises the argument that small-cap stocks may now present compelling valuations, potentially drawing in investors seeking value opportunities.

Caution Amidst Optimism

Bonne, however, cautioned against excessive enthusiasm. He pointed out that the pricing behavior of the “Magnificent Seven,” a select group of stocks featuring Apple Inc. AAPL, Microsoft Corp. MSFT, Alphabet Inc. GOOG GOOGL, Amazon Inc. AMZN, Meta Platforms Inc. META, NVIDIA Corp. NVDA and Tesla, Inc. TSLA, has played a role in widening this valuation gap.

This restricted elite of stocks has shown an 85% increase year to date, compared to the 11% of the SPY and the negative 3% of the Invesco S&P 500 Equal Weight ETF RSP.

The duration of these valuation differences between small and large-cap stocks remains uncertain, according to Bonne.

The gap may further widen if small-cap stocks face challenges due to high interest rates, or, the current market environment might represent a new norm.

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