Many investors have bemoaned the past 10 years, terming it a lost decade for stocks. But if you owned shares of smaller companies, you really haven't suffered much at all over the long haul, and the gains you've seen recently have been impressive.
Eventually, different groups of stocks move in and out of favor. So as lucrative as small-caps have been for investors for a long time, could they now have gotten so far ahead of themselves that a major crash is imminent?
The valuation proposition
For years, the U.S. stock market has had a huge split based on company size. Large-cap stocks have seen miserable returns, with the SPDR Trust returning less than 2% annually since 2001 even including dividends. Even those numbers have been skewed somewhat by the smaller components in the S&P 500; when you look instead at the megacap S&P 100 index, you'll see that it has done even worse, trailing the S&P 500's average annual return by more than a percentage point. That's why when you look at big-cap indexes, they're still well off their record highs from 2007.
On the other hand, smaller companies have performed a lot better. An ETF that tracks the Russell 2000 index of small-cap stocks has returned an average of 6.3% in the past 10 years. That doesn't compare well with the 10% returns investors hope to get over the long haul, but compared with large caps, 6% is a great result. And just last year, small caps earned a 26% return, beating out the S&P's 15% by a wide margin.
Looking forward, though, small caps face an increasingly large valuation problem. According to Credit Suisse, the ratio of small-cap valuations to large caps is the largest it has ever recorded. Based on earnings estimates for the coming year from The Wall Street Journal, the stocks in the Russell 2000 collectively trade at an earnings multiple of 24.5. In contrast, the S&P 500 gets a multiple of only 13.6.
One way to look at that phenomenon is to argue that it's a good reason why large-cap stocks should continue to rally despite their strong gains since the market meltdown. But the other possibility is that small caps could come crashing down to bring their valuations in line with their larger counterparts. If that happened, then we could be looking at a drop of 45% for the Russell 2000 index.
Are small caps ahead of themselves?
Of course, valuations by themselves only tell part of the story. To get the big picture, you need to see whether those valuations seem justified by the growth potential of the stocks in question.
To look at that further, I looked for Russell 2000 stocks that have at least doubled in the past year and that have forward P/E multiples of 50 or more. Let's focus on seven out of the 15 stocks that met that test:
5-Year Growth Estimate
Source: Capital IQ, a division of Standard and Poor's. Forward P/E based on next year's estimated earnings.
As you can see, most of these stocks have ambitious growth projections for the years to come. Given that it only takes a 15% growth rate to double earnings within five years, a 25% rate to triple them, and a 32% rate to quadruple them, even the loftiest of multiples with the stocks above could drop sharply if earnings catch up with share prices. That would prevent a crash and could even send shares of these companies soaring higher.
On the other hand, there's no guarantee that these stocks can follow through on their growth promises. And even if they do, hundreds of other stocks in the Russell 2000 may not be so lucky -- which could easily drag down the entire index.
Never say never
As with any timing-related call, it's impossible to know whether high valuations among small caps will actually cause a collapse in their prices. But by being aware of the risks, you can position yourself accordingly, concentrating on stocks that have the fundamentals to back up their lofty valuations. That's the best protection against a possible crash.
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Fool contributor Dan Caplinger tries to be prepared for anything. He doesn't own shares of the companies mentioned in this article. Acme Packet, OpenTable, and Rackspace Hosting are Motley Fool Rule Breakers choices. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has gone through more crash-test dummies than Chrysler.