Small-Cap Rally Continues: Will Large-Cap Stocks Ever Catch Up?

The S&P 500 continues to lag small-cap stocks. Find out why.

Mar 23, 2014 at 11:30AM

The S&P 500 (SNPINDEX:^GSPC) has set several all-time record highs so far in 2014, with positive performance even as the Dow has struggled with modest losses. Yet the Russell 2000 (RUSSELLINDICES:^RUT) has continued to outshine the large-cap benchmark this year, extending its long-term domination throughout the five-year-old bull market. What's behind small caps crushing the S&P, and what will it take for large-cap stocks to catch up to their smaller counterparts?

The harder they fall, the higher they rise
During the 2008 recession and financial crisis, the entire stock market sold off. But as you'd expect, many small-cap stocks got hammered much harder than large-cap stocks, because in many cases, their entire survival was threatened.

As a result, when the market recovered beginning in 2009, the fact that those small-caps had in fact survived the crisis led to some truly amazing returns. Over the past five years, the S&P 500 has averaged an impressive 19.4% annual return -- but the small-cap Russell 2000 has beaten even that impressive figure by five full percentage points.

Surprisingly, though, that trend has continued long after the initial recovery phase. Over the past year, the Russell 2000 is up 26%, compared to just 19% for the S&P 500. Indeed, even small-cap mutual fund managers can't believe the good fortune that the Russell 2000 has had lately, as more than two-thirds of fund managers underperformed the small-cap index last year, and 87% have underperformed over the past three years. That's a big vote of confidence for ETFs iShares Russell 2000 (NYSEMKT:IWM) and SPDR S&P 600 SmallCap (NYSEMKT:SLY), which seek to match popular small-cap benchmarks rather than beat them through active management.

Time to switch gears?
As a result of the long outperformance of small-cap stocks, many stock experts are starting to look at large-caps as being relatively undervalued. Joel Greenblatt, for instance, who uses his Magic Formula Investing method to pick promising stock prospects, recently said that large-cap stocks have valuations that are only mildly above their typical levels. But in contrast, he noted that small-caps have only been more expensive about 5% of the time, and he argued that the best place to invest was in the biggest of the large-cap stocks, whose valuations are actually fairly reasonable.

Still, it's no easier to try to time when large-cap stocks will start to outperform small-caps than it is to time the market on the whole. If earnings start to drop, perhaps as a result of less access to the capital markets for small companies, then small-caps could fall further than their large-cap counterparts.

The best solution is to keep both large-cap and small-cap exposure in your portfolio, all the while making sure that you keep your portfolio and risk level in balance. Rebalancing to avoid overweighting either sub-asset class makes the most sense, especially if you believe that large caps will eventually return to their outperforming ways. In the meantime, though, you don't want to make a huge bet only to have small-caps continue beating their bigger counterparts for years more to come.

Get into the market
Whether you pick large or small stocks, you can't afford not to invest. Millions of Americans have waited on the sidelines since the market meltdown in 2008 and 2009, too scared to invest and put their money at further risk. Yet those who've stayed out of the market have missed out on huge gains and put their financial futures in jeopardy. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.

Dan Caplinger and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information