We’re often told to think big.
And in fact, that’s exactly what investors have done this year.
I wrote about this odd market phenomenon last week: A handful of megacap stocks are carrying the entire market in 2023.
The S&P 500 Index is up almost 10% year to date, but the 10 largest stocks in the index account for the vast majority of that gain (about 70% of it). These stocks are the usual suspects: Apple (Nasdaq: AAPL), Microsoft (Nasdaq: MSFT), Amazon (Nasdaq: AMZN), Alphabet (Nasdaq: GOOGL), etc.
They’re also expensive.
Each of the top 10 stocks – with the exception of Berkshire Hathaway (NYSE: BRK-A), which has a wonky price-to-earnings (P/E) ratio due to its unique structure – has a P/E ratio that’s higher than the S&P 500’s.
Some of these stocks – including Amazon and Nvidia (Nasdaq: NVDA) – have P/E ratios that are many multiples of the S&P 500’s.
These stocks are becoming so expensive that a rotation into another group may be inevitable… and imminent.
Go Small
So what’s not expensive right now?
Small cap stocks. In fact, they’re on sale at the moment.
The forward P/E ratio for the large cap S&P 500 Index is now 18, according to Yardeni Research. By contrast, the P/E ratio for the S&P 600, which tracks small cap stocks, is only 12.5.
So you’ll pay a lot less for small cap stocks – companies with market caps of less than $2 billion or so – than you will for large cap and megacap stocks.
And now may be the right time to start shopping for these smaller stocks.
Research has found that small caps tend to outperform their larger cousins when the economy is recovering from slow growth, unemployment is low and corporate earnings are relatively strong.
And early bull markets are particularly good times for small caps. For example, in the first 12 months of the long bull market that followed the 2008-2009 financial crisis, the S&P 500 rose 69% – but was outpaced by the Russell 2000 index of small caps, which soared 95%.
Were it not for the banking crisis that shook the economy in early March, that might have been the case in this market too.
The Russell 2000 was outperforming the S&P 500 from the beginning of the year to March 10, when news of Silicon Valley Bank’s collapse rocked all stocks. But the crisis hit small cap indexes harder.
That’s because, while megacap banks like JPMorgan Chase (NYSE: JPM) were considered completely safe, regional bank stocks got hammered by the crisis. And those regional bank stocks make up more than 16% – a significant chunk – of both the S&P 600 and the Russell 2000 indexes.
In addition, small tech stocks – many of them reliant on the services of regional banks – also got hit hard by the banking crisis.
So small cap indexes were pushed lower by that crisis and have continued to underperform large cap indexes.
If you believe the banking crisis has largely played out and you think the economy can avoid recession this year and the bull market can continue, small cap stocks deserve your consideration.
Yes, they carry greater risk than large caps, but the payoff can be well worth it.