In recent years, the stock market has been dominated by the largest companies, particularly the tech giants known as the “Magnificent Seven.” The Russell 1000 index, which focuses on large-cap stocks, has seen a more than 14 percent increase in 2024 through the end of June, while the small-cap Russell 2000 index has only gone up by less than 2 percent during the same period.
This performance gap has resulted in small-cap stocks trading at a significant discount compared to large-caps, presenting an opportunity for investors to potentially acquire undervalued assets.
Comparison of Small-cap vs. Large-cap Performance
Large-cap stocks have significantly outperformed their small-cap counterparts recently, with tech giants like Nvidia and Microsoft experiencing share price increases due to strong business performance and optimism surrounding artificial intelligence.
Here’s a breakdown of the performance:
| Russell 1000 | Russell 2000 | |
|---|---|---|
| Note: Performance through 6/28/2024 | ||
| YTD (through June 2024) | 14.2 percent | 1.7 percent |
| 1-year | 23.9 percent | 10.0 percent |
| 3-year | 8.7 percent | -2.6 percent |
| 5-year | 14.6 percent | 6.9 percent |
| 10-year | 12.5 percent | 7.0 percent |
Outlook for Small-cap Stocks
As of June 28, large-cap stocks have a forward price-earnings ratio of around 21, compared to approximately 14 for small-cap stocks – the widest gap since the late 1990s tech bubble. Historically, small-cap stocks have outperformed large-caps in the aftermath of the tech bubble and leading up to the 2008 financial crisis.
Some investors believe that potential Federal Reserve interest rate cuts could benefit small-cap stocks, which are typically more sensitive to economic conditions and rely more on external financing. However, an improved earnings outlook for small-cap stocks could also narrow this gap.
According to Francis Gannon, co-chief investment officer at Royce Investment Partners, “Our expectation is that this dynamic will begin to reverse itself later this year as small-cap profits continue to recover via back-end loaded growth in 2024 and into 2025.”
Small Caps and the Opportunity in AI
While large-cap stocks have capitalized on the AI trend, there are still opportunities for small-cap companies to benefit from the rise of artificial intelligence. Despite the significant investments required for AI capabilities, small-caps can play a meaningful role in providing products and services supporting the AI infrastructure buildout.
David Sekera, chief U.S. market strategist at Morningstar, suggests that investors consider shifting away from large-cap AI winners, which may be trading at premium valuations. He recommends an underweight position in large-cap stocks in favor of overweighting small-cap and mid-cap stocks.
Adding Small-cap Stocks to Your Portfolio
After trailing large-cap averages for several years, small-cap stocks may be poised for a period of outperformance. If you’re interested in adding small-cap stocks to your portfolio, you can choose to invest in individual small-cap stocks or opt for an ETF that holds a diversified basket of small-cap stocks.
For a list of the best small-cap ETFs, check out Bankrate’s recommendations.
Consider rebalancing or increasing your allocation to small-cap stocks if you already have exposure in your portfolio. While large-caps have been dominant in recent years, small-caps could potentially see a resurgence in the near future.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Past performance is not indicative of future results.