Small-Cap Underperformance Is About to End

The boogeyman that investors fear has been simple this year...

Folks are worried that the biggest stocks are the only ones driving gains in the market.

It's true... The so-called "Magnificent Seven" – Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Nvidia (NVDA), Meta Platforms (META), and Tesla (TSLA) – are a big reason the market is up so much this year. In the first half of 2023, they accounted for 73% of the 16% gain in the S&P 500 Index.

That outperformance has been consistent across the market as well. A broader comparison of large- and small-cap stocks shows the larger stocks are winning... And they're beating smaller stocks at the most extreme level in more than two decades.

This isn't bad news for either group, though. In fact, similar setups have led to massive gains for both groups... with small caps rising 41% over the next year.

Let me explain…

If you want to compare large- and small-cap stocks, the best way to do it is through Russell indexes.

The Russell 3000 Index holds 3,000 U.S. stocks. For practical purposes, that's the entire U.S. stock market. And that index can be broken down into two more indexes...

The Russell 1000 holds the largest 1,000 U.S. stocks, representing 93% of U.S. market capitalization. And the Russell 2000 – which holds the smallest 2,000 U.S. stocks – is the benchmark for small caps.

The easiest way to see if large caps are outperforming small caps is to get a ratio of the two indexes. That's what I did in the chart below, dividing the large-cap index by the small-cap index. Take a look...

The ratio rises when large caps are beating small caps. And as you can see, it's currently at a multidecade high. We haven't seen large caps pull this far ahead of small caps since 2001.

You'll also notice a handful of similar periods I highlighted. These are four other instances when the ratio either broke through or got close to today's level. And importantly, each setup was a darn good time to buy stocks.

Notice that I didn't specify small-cap stocks in the last sentence. That's because in all cases, both large caps and small caps soared. Here's what happened with large-cap stocks, measured by the Russell 1000...

You might expect large caps to slow down after a period of big outperformance. But that didn't happen. Instead, the Russell 1000 soared. And buying large caps after a setup like today's led to a 15% gain in six months and a 27.6% gain over the next year.

That crushes the typical buy-and-hold return. But if you want to do even better, then it's true – you'll want to buy small caps after this kind of situation. Take a look at the Russell 2000's returns since 1978...

For small caps, the outperformance was even more striking. The typical gain soared to 21.3% over six months and 40.5% over a year. And in both cases, that was nearly five times better than the buy-and-hold return on the Russell 2000.

We have two big takeaways from this. The first is that buying small caps is a smart idea right now... But at the same time, large-cap outperformance doesn't mean the big stocks are about to fall.

History shows both large and small stocks can do well from here. But as this extreme unwinds, small caps should see the biggest gains. And that makes small-cap stocks a good bet today.

Good investing,

Brett Eversole

Further Reading

"Septembers are tough for stocks – and last month was a real killer," Sean Michael Cummings explains. But that underperformance could be setting up a great buying opportunity – because stocks tend to surge after times like these, based on history... Learn more here.

Market pullbacks, whether big or small, can create incredible bargains. And you don't need to sift through stacks of financial reports to find the winners. One man's story shows the benefits of keeping cool and investing for the long term – even if everyone else is panicking... Read more here.