Small caps show signs of life

Small cap stock indexes are having their best month in years, with the S&P 600 up more than 8.50% so far in November. You’ve probably never heard of the S&P 600, so let’s touch on that first. 90% of the entire US equity market is represented by the S&P 1500 (another index you’ve probably never heard of). The S&P 500 is the 500 largest companies in the S&P 1500. The S&P 400 is the next 400 biggest companies, #501-900. The S&P 600 is the smallest 600 companies in the S&P 1500, #901-1500.

Add the three indexes together, and you end up with 1500 stocks. For the last few years, the largest 500 stocks (S&P 500) have been beating the smallest 600 (S&P 600). Historically, however, smaller stocks have done better than large. And we’re wondering if that trend may have restarted in the last few weeks.

Looking at historical performance

Small cap stocks have trailed large cap stocks by 2.0-2.5% per year over the last 5-10 years. But if you were to look back over the last 50-80 years, small cap stocks have beaten the S&P 500 by 2.0-2.5% per year:

We have a couple of theories for why performance has shifted in the last 5-10 years. First is the growing popularity of index investing and retail investing. As investors have poured more money into broad market index funds, those funds have, by rule, been forced to buy the largest companies in the index. Think about it like this: if you’re an index fund and your goal is to “track an index,” every time investors buy more of your index fund, you must buy more of the companies that make up the index you’re tracking.

The most popular index funds are those that track the S&P 500. Thus, there’s been a circular cycle of S&P 500 stock buying in effect over the last decade. Look at the overall rising trend of inflows since 2008, and then the massive inflow that took place from 2020-2022:

Secondly, the rise of the retail investor has been another positive catalyst for S&P 500. Research has shown the retail investor greatly favors the largest and most well known stocks in the market, like Apple, Amazon,  Tesla, Microsoft, and Google. These five companies make up the largest holdings in the S&P 500. So as their share prices have risen, they’ve helped power the S&P 500 higher. In effect, S&P 500 outperformance has been a simple case of follow the money.

So why not just buy the S&P 500 and call it a day?

A common question we’re hearing is if the S&P 500 is performing better than small cap stocks, why own any small cap indexes at all? If we have logical reasons for why the S&P 500 will keep attracting investor money, won’t it continue to outperform the other indexes? The short answer is no. Why not? Because we believe markets weed out inefficiencies over time.  If everyone is piling into a certain area of other market, that area of the market will have to correct.

Bubbles are great examples of the inefficiency/efficiency rhythm that markets experience. In the late 90’s, tech stocks went up 100%… they looked overvalued… then they went up another 100% in 1999! But, by 2002, tech stocks had fallen nearly 80% from their peak. Yes, you could have made money buying tech stocks in 1998 after they had already went up huge, but navigating those seas proved treacherous.

Look at the valuations

While the S&P 500 is not in a bubble from a valuation perspective, we can measure its fundamental value, along with small cap stocks, by looking at price-to-earnings ratios (P/E). This ratio measures how much investors are willing to pay for $1 of earnings a company generates. For example, a P/E of 10 means that you are paying $10 per share for every $1 in corporate earnings that a company generates.

Investors are currently paying 19 times earnings per share for the S&P 500 compared to just 13 times earnings per share for smaller companies in the S&P 600:

The price to earnings ratio investors are paying for the 8 most popular and largest tech stocks in the S&P 500, referred to as the “Mega-Cap 8” is at a more extreme level of 28:

The valuation premium of the MegaCap-8 illustrates how fund flows and the popularity of the crowd can overwhelm fundamentals. However, this is a classic example of a market inefficiency that we expect will be corrected over time.

What could that correction look like?

Much of our thesis that small cap stocks could start outperforming large stocks relies on two premises:

1. In general, you want to avoid the most popular areas of the market. There’s no bet more popular in the market right now than the one being placed on the S&P 500, and especially tech stocks inside of the index itself.
2. When the popularity contest of the market is over, investors usually turn back to fundamentals. By that reasoning, with valuations near 20 year lows, small cap stocks offer upside.

Looking back at the last few times small cap stocks traded with a P/E ratio of 13 or lower, like they do now, forward returns were very strong:

Small cap stocks averaged 1, 3, and 5 year returns of 8%, 15.54%, and 16.10% since 2000 during the other instances that the index traded with a P/E of 13 or less (like it does now).

Let’s compare versus the S&P 500

To really decide if small cap stocks were the place to be during these low valuation periods, let’s compare those returns to the S&P 500 during the same periods:

Overall, the performance of small cap stocks versus the S&P 500 was much better across all time frames whenever the small cap index P/E ratio was below 13. Not just by a small amount either, the annualized outperformance of small cap stocks versus the S&P 500 was greater than 6%, on average, across all time frames:

This outperformance is equal to an extra $6,000 worth of returns per $100,000 invested in small cap stocks over the S&P 500. So while an oversized allocation to small cap stocks in the last few years has resulted in lagged performance vs the S&P 500, we wouldn’t be surprised if that trend reverses course over the next 1-3 years.

Keep in mind, small cap stocks have historically outperformed large ones over the last 50-80 years. And today, valuations are in your favor. If you’re looking to get index exposure to small cap stocks, consider ETF tickers like SPSM, IJR, or DFAS. These are three low-cost index funds that will do very well if the November rally in small cap stocks continues.