The stock market has been on an absolute tear over the past three years. Since bottoming in October of 2022, the S&P 500 (^GSPC 0.24%) is up 91%. The tech-heavy Nasdaq Composite (^IXIC 0.26%) has more than doubled in the same period.
But there's growing concern that some of the biggest driving forces in the current bull market may be in a bubble. Just a handful of large companies have seen meaningful financial impact from the growth of artificial intelligence (AI), but practically all large-cap U.S. companies have seen their valuations climb. That has led economist Robert Shiller to provide a dour forecast for the S&P 500 over the next decade.
They say history doesn't repeat itself, but it often rhymes. And if we are indeed in a bubble, there's one stock market indicator that provides a clear signal on where to invest now. It steered investors right amid the dot-com bubble's pop, and it could prove valuable again today.
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The big valuation gap that's tough to ignore
While many of the world's largest companies are reporting strong earnings growth, their stock prices have climbed faster than their bottom-line results. As a result, the index now trades at an elevated forward P/E ratio of around 21.9, well above the mid-to-high-teens multiple it historically trades around.
But smaller companies haven't seen their earnings multiples expand nearly as much. The S&P 600 small-cap index trades at just 14.8 times forward earnings estimates, well below its highs of 2020 and 2021. That P/E gap of 7.1 points is one of the highest on record since the dot-com bubble popped. You have to go back to early 2001 for the last time the valuation gap was this stretched.
To some degree, small-cap stocks deserve a lower multiple. The S&P 500 has grown its earnings at a double-digit pace annually, driven by AI and growth at the world's largest companies. Meanwhile, the small-cap index has seen its earnings growth stall over the last two years, with a decline in 2023 and flat earnings in 2024.
But analysts are bullish on the future of small companies, with consensus expectations for around 20% earnings growth in 2026 and only a slight slowdown in 2027. Granted, analysts have been overly optimistic about small-cap stocks in the recent past, but there are a few reasons to expect a rebound in small-cap earnings growth over the next couple of years.
The Federal Reserve is expected to deliver additional rate cuts over the next year. Traders are expecting three or four cuts by next December based on the futures market. As interest rates come down, smaller companies should see a boost in profits and increased spending power, as many rely on floating-rate interest loans to finance operations instead of bonds.
U.S. small caps are also more insulated from tariffs and could benefit from a domestic economic rebound. There's also a case to be made that smaller companies have yet to fully benefit from the artificial intelligence opportunity, which could put them on a more equal playing field with much larger companies in some ways.
How you can take advantage of the gap
If you want to invest in small-cap stocks, you could research individual stocks. But digging up data and finding news about smaller businesses is significantly more challenging than researching large companies. There's not as much analyst coverage or reporting on small stocks. But if you're willing to do the work, you could find some great investments.
A much easier strategy is to buy an ETF that holds a basket of quality small-cap stocks. If you want to keep it as simple as possible, an S&P 600 ETF like the iShares Core S&P Small-Cap ETF (IJR +0.56%) is a great option. Its low expense ratio of 0.06% and excellent record of tracking the index make it a great way to produce returns in line with the S&P 600.
NYSEMKT: IJR
Key Data Points
Another option is the Avantis U.S. Small Cap ETF (AVUV +0.59%), which filters stocks from the Russell 2000 Value index based on profitability metrics in an attempt to exclude value traps from the fund. That strategy enabled the fund to limit losses in 2022 and outperform the S&P 600 in the rebound in 2023. It's performed roughly in line with the index throughout the rest of its history since its establishment in 2019. If we experience similar volatility in the coming years, the Avantis strategy may prove valuable once again; however, it also carries the risk of underperformance since it's not an index fund.
With the stock market indicating small-cap stocks are extremely undervalued relative to large-cap stocks, it may be time to put some of your capital to work in one of the above ETFs.
