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Small company stocks (and mutual funds that invest in them) just keep kicking big stocks around the stock exchange. This has been going on for over 10 years and, so far, the trend continues in 2011. If history is a guide, that relationship will eventually reverse itself and large cap stocks will do much better than small cap stocks. The last time we saw this was back in the late, lamented 1990s. Since then, small has been beautiful.

This chart (click to enlarge) shows the long-term relationship between price-earnings ratios for small cap stocks compared to very large cap stocks. Currently, the PE ratio for a small stock index such as the Russell 2000 is much higher than the PE ratio for large stocks in the Russell 200. In this chart, large caps PE ratios are closing in on small cap PE ratios when the line is falling and small caps are outperforming when the line is rising. As you can see, it has been a long dry spell for large company stocks.

Source: Wall Street Journal

The Wall Street Journal reports on this trend and adds some historical context [emphasis added]:

…Small companies now command the widest premium over large-cap stocks in at least a generation, based on the ratio of price to earnings…

The Russell 2000 is trading at almost 18 times one-year forward forecast earnings, a record high, according to Bank of America Merrill Lynch. That P/E ratio is about 1.3 times the P/E of the market’s largest 200 companies as measured by Russell Indexes, according to Lori Calvasina, director of small-cap equity strategy at Credit Suisse, the highest since at least 1979, when her data begin.

The valuation gap has approached this level only twice before, in 1983 and 2007. After both instances, small-cap stocks vastly underperformed their larger brethren, Ms. Calvasina says…

We have been in a favorable time for small company stocks since the end of the love affair with large growth and technology companies. In 2000, we entered a bear market for large stocks, but small stocks hung in there pretty well. Another factor that has favored small stocks is the low level of interest rates that has been in effect for much of the last 10 or so years.

In short, eventually, this cycle will reverse and small company stocks will languish as a group. However, it is unlikely that small company stock outperformance is going to go away as long as this cyclical upturn in the stock market continues. The Wall Street Journal continues:

…As investors tiptoe back into stock mutual funds, some argue that the investors that have so far missed the small-cap rally may be tempted to jump in. “Small-cap stocks have been persistently out of favor, even as they’ve been persistently outperforming large caps,” says James Paulsen, chief investment strategist at Wells Capital Management. “It’s doubled while nobody’s been in it, and that’s what allows it to keep going.”

If you are considering a big commitment to small company stock funds, I think you’re late to the party. Small has been outperforming large since 2001 or so. That’s a long run. That does not mean you should rule out small company mutual funds or ETFs, just that you must bear in mind where we are in the cycle.

And, if you are considering the move just because you’re attracted by the strong returns, be careful because chasing returns seldom works well.

Source: Small Caps Still Beating Out Large Caps