A Surge Could Be Coming for Small Cap Stocks

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Editor’s Note: Since Jody’s gone above and beyond and given you eight Value Meter evaluations over the past three weeks, we decided to give him this week off.

So, instead of a normal Value Meter, we’re sharing a special treat with you today: Jody’s most recent essay in Chief Income Strategist Marc Lichtenfeld’s monthly newsletter, The Oxford Income Letter. It’s all about why Jody believes “a small cap surge is near.”

Speaking of small caps, I can’t give too much away here… but The Oxford Club’s Chief Investment Strategist Alexander Green is hosting a free training next week called “How to Build the Perfect Fed-Proof Portfolio,” and it’s safe to say small caps will be featured heavily. The event takes place on Wednesday, December 6, at 1 p.m. ET.

Alex’s trainings are always incredibly illuminating, so make sure you sign up HERE! (Even if you can’t make it live, I still encourage you to register – we’ll send you a recording in the days after the event!)

– Rachel Gearhart, Publisher

For the past decade, the market has been dominated by large cap growth stocks.

Between December 31, 2012, and December 31, 2022, the Russell 1000 Growth Index (which is made up of large cap growth stocks) outperformed the Russell 2000 Growth Index (which is made up of small cap growth stocks) by nearly 5% per year.

And it hasn’t been among just growth stocks that large caps have dominated. The chart below compares the total 10-year return of the iShares Core S&P Small-Cap ETF (NYSE: IJR) with that of the large cap-heavy S&P 500.

These two indexes include growth and value stocks, and the chart shows that large caps have had a terrific run.

Chart: A Decade of Large Cap Domination

Given this long-term outperformance from large cap stocks, you won’t be surprised to learn that – right now – small caps offer an attractive value proposition.

The ratio of the Russell 2000 (which is composed of small cap stocks) to the Russell 1000 (which is composed of large cap stocks) is currently at a 22-year low. We haven’t seen small caps this inexpensive relative to large caps since the turn of the century.

Chart: Tough Times for Small Caps

Interestingly, the last time the ratio hit this level was one of the best moments in history to pick up small cap bargains.

Beginning in 2001, small caps outperformed large caps by more than fourfold over the following 13 years.

Chart: Small Caps' 13 Years of Outperformance

Also, it’s important to note that small cap stocks aren’t cheap only relative to large caps. They’re cheap on an absolute basis as well.

With a forward price-to-earnings (P/E) ratio of 12.6, small cap stocks, as represented by the S&P SmallCap 600 Index, have rarely been less expensive.

The only two times this index has traded at a lower forward P/E ratio in the past 20 years were at the bottom of the financial crisis in 2008 and during the COVID-19 crash in March 2020.

Chart: Small Caps Are Also Cheap on an Absolute Basis

Those were two other moments when buying small caps paid off incredibly well.

The case for small caps is already convincing, yet there is even more data that supports stocking up on small caps now.

Earlier this year, the Russell 2000 Index declined in value over four consecutive months. This is an extremely unusual occurrence.

Since the Russell 2000 was created in 1984, it has gone down in four consecutive months only eight times.

And the returns for the index coming out of these drops have been exceptionally strong. One-year returns have averaged 24.7%, three-year returns have averaged 21% and five-year returns have averaged 16.8%.

Chart: Small Caps Shine After 4 Down Months

The recent four-month decline of the Russell 2000 suggests that small caps could be ready for another long run of strong performance.

While large caps are rather expensive at the moment, small caps offer an almost historically attractive value.

It is no wonder, then, that Marc doubled down on small cap dividend payers at The Oxford Club’s Private Wealth Seminar at Lake Tahoe just a couple of months ago.

The stock market moves in cycles. Large caps have had the lead for an unusually long time. I believe that a small cap surge is near, and the valuation data supports that belief.

There are plenty of small cap businesses that now offer solid dividends, great balance sheets and very attractive valuations. Income investors should take note and get their portfolios ready.

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