The stock market is moving like it hasn’t in 23 years, which could signal a big investment opportunity.

Consistent investment in the stock market is proven to create wealth. Over the long term, stocks generate higher returns than most other asset classes.

While stocks as a whole have risen consistently over time, economic cycles cause some segments to outperform others when viewed for several years at a time. Over the past few years, large technology stocks have driven gains in the overall stock market. More recently, artificial intelligence (AI) has driven a major increase in the share prices of the world’s largest technology companies.

But the cycle may be about to turn: Certain indicators suggest that certain segments of the market are historically undervalued, which could present a golden opportunity for investors.

Image source: Getty Images.

The large valuation gap in today’s stock market

Indicators that investors should pay attention to include: S&P 500 Index and S&P 600 Index. The S&P 500 tracks roughly 500 of the largest, consistently profitable U.S. companies. The S&P 600 is its smaller-company index.

As of early June, the S&P 500’s composite forward P/E was 20.3, compared with just 14.5 for the S&P 600, a difference of 5.8 percentage points. The gap has hovered around 6 percentage points so far this year, reaching levels not seen since mid-2001.

Small-cap stocks have historically outperformed larger ones — and the small-cap value stocks that the S&P 600 focuses on have performed even better — but that outperformance has been intermittent.

The last time the valuation gap between large and small caps was this wide was when small caps far outperformed large caps. The S&P 600 returned a total return of 69% over the five years from mid-2001, compared to just 13.1% for the S&P 500 over the same period. In the 10 years since mid-2001, a period that included the end of the dot-com bust and the Great Recession, the indexes returned 111.8% and 30.8%, respectively (the Great Recession hit small caps just as hard as large ones).

Data by YCharts.

Reasons for the valuation gap

There are several reasons for the historic valuation gap between large and small cap stocks when it comes to 2024 market conditions.

Large-cap indexes are currently heavily weighted toward a small number of big tech stocks: The “Magnificent Seven” that have driven stock market returns over the past 18 months make up more than 29% of the S&P 500. And these stocks are valuated much higher than average.

Mega Cap 8 includes the Magnificent Seven (apple, alphabet, Amazon, Meta Platform, Microsoft, NVIDIAand Tesla) and NetflixAccording to Yardeni Research, MegaCap-8 has a forward P/E ratio of 28.9. The S&P 500 has a forward P/E ratio of 20.3, and 18.3 excluding MegaCap-8.

The heavy weighting of a few big tech stocks is reminiscent of the market at the height of the dot-com bubble in 2000. While valuations aren’t as high as they were then, it reinforces the notion that small and mid-cap stocks will dominate over the next few years while big tech stocks could get a breather.

Image source: Getty Images.

But there’s a reason small-cap stocks have been selling off recently: The S&P 600 is trading at 14.5 times forward earnings, at the low end of its historical average.

One big reason small-cap stocks are priced so low is the impact that interest rates have on their businesses and the market as a whole. Small-cap stocks generally have higher floating interest rates than longer-term bonds. So when interest rates rise, smaller companies feel the pain of higher interest expenses more keenly.

Adding to this challenge, rising bond yields have led investors to demand a larger risk premium for small-cap stocks, putting pressure on prices.

But the tide seems to be turning for small caps. Investors expect the Fed to cut interest rates this year and into next. Meanwhile, the rapid growth of big tech companies, fueled by AI, is sure to become a reality. This bodes well for small caps to outperform large cap indexes in the coming years.

How to invest in today’s market

There are a few ways to add small caps to your portfolio. You can also research individual companies to find the best publicly traded small caps. These companies are not as widely followed, so they may have a great opportunity to outperform.

But consistently beating an index is tough, even for the pros: Fewer than 12% of active small-cap mutual funds have outperformed the S&P 600 over the past decade, after fees are deducted.

That’s why one of the best ways to invest in small-cap stocks is through an index fund. You can buy a fund like the S&P 600 index fund. SPDR S&P 600 Small Cap ETF (SPSM -1.12%)It simply tracks the S&P 600 and charges a very low expense ratio of 0.03%.

If you want a broader index of small cap stocks, Russell 2000Unlike the S&P 600, this index has no profitability requirements and simply tracks the smallest 2,000 companies from the broader Russell 3000 index, which aims to track the entire market, and as a result, includes some mid-cap and growth stocks as well.

That said, the S&P 600 has historically outperformed the Russell 2000. Vanguard Russell 2000 ETF (V2O -1.14%) Its low expense ratio makes it a great option.

Among small cap stocks, value stocks have tended to outperform other stocks over the long term, and while the S&P 600 is biased toward value stocks, investing in an ETF that focuses on small cap value stocks can give you more concentrated exposure to this factor. Avantis US Small Cap Value ETF (AVUV -0.80%) We use profitability and valuation metrics to select a broad portfolio of small-cap value stocks that seek to outperform the Russell 2000 Value Index.

All of the above are great choices in today’s market, and while it may take some time for the tide to turn for small-cap stocks, we expect this segment to outperform in the coming years.