Why Allocating to Small-Cap Stocks Might Be a Good Idea Right Now
If you are feeling uneasy about the high market concentration and lofty valuations of large-cap stocks, it might be time to consider adding small caps to your portfolio. Apart from the concentration and valuation concerns, there are several compelling reasons to think about investing in small-cap stocks at this time.
As the US stock market reaches new all-time highs, the market concentration among large-cap stocks has also soared to levels not seen since the Tech Bubble. With the top 10% of companies accounting for about 66% of the total market cap of the Russell 1000 Index as of May 31st and the index’s high price-to-earnings (PE) ratio, it’s clear that large-cap stocks are looking overvalued.
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data is from 1/1980 to 5/2024. Stock concentration is the percentage of total market cap by the top 10% largest companies in Russell 1000 Index.
More Attractive Fundamentals
After years of technological advancements, tech sectors like Information Technology and Communication Services now make up more than 38% of the total weight of the Russell 1000 Index. The valuations of mega-cap firms in these sectors have been driven by high growth expectations. In comparison, small-cap companies in the Russell 2000 Index have more moderate and normalized sector weights and PE ratios.
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. As of May 31, 2024.
When comparing small-cap stocks to large caps historically, small caps are currently trading at a significant discount. The forward PE ratios of small caps over large caps were 73% as of May, indicating a 27% valuation discount for small caps. Such a low valuation discount ratio suggests that small caps are poised for growth and outperformance in the coming years.
Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data is from 3/1990 to 5/2024. Exclude stocks with negative earnings.
Small Caps do Better When the Economy Recovers
Small-cap companies are more sensitive to economic conditions and tend to be more correlated with economic cycles compared to large-cap companies. As the economy starts to recover and expand, small caps have historically rebounded the most due to their attractive valuations.
