Go big or go home. That adage has served investors pretty well so far in 2023.
The S&P 500, which includes the biggest stocks in the U.S., has soared close to 16% year to date. Meanwhile, two small-cap indexes -- the S&P SmallCap 600 and the Russell 2000 -- are up only 4% and 6%, respectively.
But don't be surprised if those dynamics change. Small-cap stocks could now be the smartest pick for investors in over 20 years.
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Large-cap vs. small-cap
One chart goes a long way toward explaining why small-cap stocks could be poised to outperform going forward. Note the gap between the levels of the large-cap S&P 500 and the small-cap S&P 600 since the creation of the small-cap index in 1994.
The S&P 500 has always been higher than the S&P 600 because of the way the two indexes are structured. However, never has the large-cap index outperformed its small-cap counterpart to the degree it is now.
But this chart by itself isn't enough to justify the claim that small-cap stocks are now the smartest pick for investors in over 20 years. Perhaps large-cap stocks delivered such stronger earnings growth compared to small-cap stocks that the gap between the two is warranted. It's easy to blow that theory out of the water, though.
Yardeni Research regularly compares the forward price-to-earnings ratios for the S&P 500 and the S&P 600. The forward P/E for the large-cap index currently stands at 19.1, while the forward multiple for the small-cap index is 13.4. This reflects the biggest valuation gap between the two indexes since the dot-com bubble burst in 2001.
Lessons from history
In the past, wide valuation gaps between the S&P 500 and S&P 600 eventually narrowed considerably. That's exactly what happened following the dot-com bubble period. By late 2002, the forward earnings multiples of the S&P 500 and S&P 600 were nearly the same.
But the gap could be reduced by both indexes falling with the S&P 500 sinking more than the S&P 600. That was the case in the early 2000s. However, there's a pretty good argument to be made that large-cap stocks are overvalued right now while small-cap stocks aren't.
The S&P 500 traded at a higher forward earnings multiple in the latter part of 2020 through late 2021. Other than that period, though, the large-cap index hasn't been this expensive since its post-dot-com bubble decline.
Meanwhile, the S&P 600 is rebounding from one of its lowest valuations (based on forward earnings multiples) ever. The only times when small-cap stocks were cheaper were during the crash of 2008 and the COVID-19 sell-off in 2020.
Investors' alternatives
Investors hoping to profit from a potential resurgence of small-cap stocks could buy individual stocks. There are thousands of them from which to choose. However, small-cap stocks can be riskier than large-cap stocks.
Another good alternative is to invest in small-cap index funds. Two of the best picks, in my view, are the Schwab U.S. Small-Cap ETF (SCHA 0.73%) and the Vanguard Small-Cap ETF (VB 0.54%).
Both of these exchange-traded funds (ETFs) own large baskets of small-cap stocks. SCHA currently has 1,765 holdings, while VB has 1,456 positions. They both also have really low expense ratios, 0.04% for SCHA and 0.05% for VB.
Keep in mind, though, that the valuation gap between large-cap and small-cap stocks could remain wide longer than anyone expects. The S&P 500 should also still deliver solid returns over the long term.
Yes, I believe that small-cap stocks are the smartest picks for investors in over 20 years. However, that doesn't mean you should go small or go home.