The Rally's Not Over

This column was adapted from the April issue of Motley Fool Hidden Gems.

It's been a phenomenal four years for small caps, and the tides don't seem to be changing just yet. Small caps are up more than 10% for the year, and by the middle of March, the Russell 2000 had closed at an all-time high 14 separate times. You may recall that a lot of market pundits were declaring that this -- surely -- would be the year that large-cap stocks would finally outperform small caps.

And it may well be, before it's all over. There's plenty of time left, and large caps have not lagged small caps by all that much this year. Sooner or later, the bigger stocks will have their day in the spotlight. In fact, large caps had about 1,500 of those days between 1995 and 1998.

So, should you be entrusting your hard-earned money to small caps now, after this fantastic run? Throwing your money into whatever corner of the market has been the latest hot sector is almost always a good way to underperform the market's averages.

Let's go to the numbers
In evaluating where the small-cap market is in relation to large caps, let's start by looking at how companies of various sizes are being priced in the market. Here are the price-to-earnings (P/E) ratios as of Feb. 28, 2006, for various Russell indexes in order of largest cap to smallest cap.

Russell Top 50 (Mega cap): 16.5
Russell Top 200 (Large cap): 17.1
Russell Midcap: 18.9
Russell 2000 (Small cap): 20.7
Russell Microcap: 21.4

This proves that the smaller the company, the more expensive it is -- at least as measured in terms of P/E ratio. In fact, this data may even understate the expense, because each of these averages excludes companies that have negative earnings and because there is a higher percentage of small caps (vs. large caps) with negative earnings. But how does that square up with history?

Stand strong
In his book, Beating the Street, Peter Lynch gave a handy reference about when to hold them and when to fold them when you've got a handful of small caps. His measure was to compare the P/E ratio of the holdings in the T. Rowe Price New Horizons Fund (PRNHX), a small-cap growth fund, against the P/E ratio of the S&P 500. When this ratio is at 2.0 or above, history shows you're not going to do well. When the ratio is at 1.0 to 1.2, it's time to load up.

T. Rowe Price New Horizons Fund top holdings

SPDRs (SPY) top holdings

As of the end of last year, the ratio was 1.6 (it's closer to 1.8 for the top five holdings listed above), which means we've got a yellow light in front of us -- small caps don't appear cheap, nor are they close to the red zone.

If yellow turns to red .
If that ratio gets any higher, however, you should slow down. In our Motley Fool Hidden Gems small-cap newsletter service, I won't stop my search for the market's best small caps. Rather, I'll become even more focused on the value side of the small-cap field.

While I'll continue to keep a close watch on the danger signs of overpricing, small caps still appear to be a good place to find new investments. The rally is not over just yet.

If you'd like to view our best small-cap ideas right now, click here for a free trial of Hidden Gems.

Fool co-founder Tom Gardner owns shares of Microsoft. Bill Barker does not own shares of any company mentioned in this article. Microsoft is an Inside Value recommendation. Bank of America is an Income Investor recommendation. The Fool'sdisclosure policydoes not have a P/E ratio.