Key Points
Large-cap stocks such as Nvidia, Tesla, and Meta have been dominating the market despite the historical premium of small-cap stocks.
Small-cap stocks are currently trading at more appealing valuations compared to bigger ones, with large-cap valuations decreasing, leaving small caps as the most attractively priced segment, trading at a 19% discount compared to historical levels.
Is it finally time for small-cap and mid-cap stocks to surpass the long-time leadership of large caps?
Stocks that have been driving the performance of large-cap indexes this year include familiar names such as Nvidia Corp. NASDAQ: NVDA, Tesla Inc. NASDAQ: TSLA and Meta Platforms Inc. NASDAQ: META, as well as Royal Caribbean Cruises Ltd. NYSE: RCL and PulteGroup Inc. NYSE: PHM.
The small-cap premium
Despite the historical tendency for small-cap stocks to outperform their larger counterparts over time, large-cap stocks have been dominant. This phenomenon, known as the small-cap premium, is attributed to the greater risk associated with smaller companies, which leads to increased potential for growth. However, large caps have thrived due to higher borrowing costs, the quest for income amid economic uncertainties, and the leadership of big techs driven by AI in 2023.
Year-to-date, technology stocks in the Technology Select Sector SPDR Fund NYSEARCA: XLK and the Communication Services Select Sector SPDR Fund NYSEARCA: XLC have been the big leaders, although eight of the S&P sectors are up this year.
Attractive valuations for small caps
Small caps are currently trading at more attractive valuations relative to larger stocks, which could attract investors looking for equities at less inflated levels.
Favorable P/Es for small caps
According to a Bank of America November research report, the small-cap Russell 2000 forward price-to-earnings ratio has fallen to a 14-month low, currently at 12.3 times forward earnings. Additionally, the Russell MidCap P/E fell to 14.6 times forward earnings from 15.1 times, which is below the historical average.
Optimism about small biotechs
Analysts are optimistic about several small-cap stocks in the healthcare sector, such as Avid Bioservices Inc. NASDAQ: CDMO, Vir Biotechnology Inc. NASDAQ: VIR, and Arcus Biosciences Inc. NASDAQ: RCUS, which are all expected to triple in price in the next 12 to 18 months, according to Wall Street forecasts.
Other factors favoring small caps
Of the SPDR Portfolio S&P 600 Small Cap ETF NYSEARCA: SPSM components that have reported third-quarter results, more than three quarters beat analyst estimates. In addition, lower interest rates can benefit small caps, as their cost of capital decreases, and presidential election years frequently result in solid gains for small-cap stocks.
Small-cap stocks outperformed their larger peers in the Thanksgiving-shortened session on November 24, and while one holiday session doesn’t indicate a trend, smaller stocks could potentially rotate into leadership.
