The stock market is doing something it hasn’t done in 23 years, and it could represent a big investment opportunity

Consistently investing in the stock market is a proven wealth creator. Over the long term, stocks generate better returns than almost any other asset class.

Stocks as a group continue to increase in value over time, but zooming in on a few years at a time causes some sectors to outperform others as economic cycles unfold. Over the past few years, large technology stocks have driven the overall stock market higher. Most recently, artificial intelligence (AI) has caused a significant surge in the prices of the world’s largest technology companies.

But the cycle may soon change. One indicator suggests that certain sectors of the market are historically undervalued and could be a good opportunity for investors.

Image source: Getty Images.

Huge valuation gap in the current stock market

What index investors should pay attention to is the gap in futures price-to-earnings (P/E) ratios. S&P 500 Jisoo and S&P 600 index. The S&P 500 tracks approximately 500 of the largest consistently profitable companies in the United States. S&P 600 is an index that corresponds to small and medium-sized companies.

As of early June, the overall forward P/E for the S&P 500 was 20.3, compared to just 14.5 for the S&P 600. This is a gap of 5.8 points. The gap has hovered around 6 points since the beginning of the year, reaching levels not seen since mid-2001.

Historically, small-cap stocks have performed better than large-cap stocks. And the small-cap value stocks favored by the S&P 600 have an even better track record. But great performance starts with fit.

Last time, the valuation gap between large and small stocks was this wide. Small-cap stocks easily outperformed large-cap stocks. The S&P 600 delivered a total return of 69% over the five years starting in mid-2001, compared to just 13.1% for the S&P 500 during that period. In the ten years since the dot-com bubble pop and the end of the Great Recession in mid-2001, the indices have returned 111.8% and 30.8%, respectively. (The latter hit the small caps as much as the big ones.)

Data from YCharts.

Why the valuation gap is so big

Regarding market conditions in 2024, there are several reasons why there has historically been a valuation gap between large and small caps.

Large-cap indices are currently concentrated on just a few large technology stocks. The ‘Magnificent Seven’, which has led stock market returns over the past 18 months, accounts for more than 29% of the entire S&P 500. And the value of these stocks is much higher than average.

Magnificent Sevenapologize, alphabet, Amazon, meta platform, microsoft, nvidiaand tesla) and netflixIt has a forward P/E of 28.9, according to Yardeni Research. The S&P 500 forward P/E ratio is 20.3, and if you strip out MegaCap-8 it is only 18.3.

The high exposure to a few large technology stocks is reminiscent of the market in 2000, at the height of the dot-com bubble. Although valuations are not as high as they were back then, it reinforces the idea that large tech stocks can take a breather while small caps take the lead over the next few years.

Image source: Getty Images.

That said, there is a reason why small-cap stocks have been collapsing recently. The S&P 600 forward P/E is 14.5, which is at the bottom of historical averages.

One of the biggest reasons small-cap stock valuations are low is the impact interest rates have on those companies and the overall market. Small-cap stocks generally have higher variable interest rates than long-term bonds. Therefore, when interest rates rise, small and medium-sized businesses feel more pain due to increased interest costs.

Making matters more difficult, as bond yields improved, investors demanded a larger risk premium for small-cap stocks, putting pressure on prices.

However, the trend appears to be shifting towards small caps. Investors expect the Federal Reserve to cut interest rates from this year to next. Meanwhile, the rapid growth of big tech based on AI will become a reality. This bodes well for small-cap stocks to outperform large-cap indices over the next few years.

How to invest in the current market

There are several ways to add small-cap stocks to your portfolio. You can find the best publicly traded small-cap stocks by researching individual companies. These companies are not widely supported, which means there may be a good opportunity for them to perform better.

However, even experts struggle to beat the indices consistently. After taking fees into account, less than 12% of active small-cap mutual funds have outperformed the S&P 600 over the past decade.

That’s why one of the best ways to invest in small-cap stocks is through index funds. You can purchase the following S&P 600 index funds: SPDR S&P 600 Small Cap ETF (SPSM -1.12%). It simply tracks the S&P 600 and charges a very small expense ratio of 0.03%.

If you want a broader index of small-cap stocks, you can use: Russell 2000. Unlike the S&P 600, this index has no profitability requirements. It simply follows the smallest 2,000 companies in the broader Russell 3000 index, which aims to track the overall market. Accordingly, the number of mid-cap stocks and growth stocks is also increasing.

That said, the S&P 600 has historically outperformed the Russell 2000. Vanguard Russell 2000 ETF (VTWO -1.14%) A great option with a low cost ratio.

Among small-cap stocks, value stocks have outperformed the rest of the group over the long term. While the S&P 600 leans toward value stocks, you can get more concentrated exposure to this factor by investing in ETFs that specifically focus on small-cap value stocks. that much Avantis U.S. Small Cap Value ETF (AVUV -0.80%) We use profitability and valuation criteria to select a broad portfolio of small-cap value stocks that aim to outperform the Russell 2000 Value index.

All of the above options are great options in the market today. It may take time for the tide to turn to small-cap stocks, but all signs point to the sector being poised to outperform in the coming years.