This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Small-caps Looking Pricey After Big Run

Stocks in this article: IVV IWM

By John Spence

The Russell 2000 Index is up more than 30% this year compared with a gain of nearly 26% for the S&P 500 Index, leading to concerns that small-cap stocks are getting too expensive after such a strong rally.

The long-term outperformance of small-cap stocks has been well-documented by recent Nobel Prize winner Eugene Fama and others, although they tend to be more volatile than the S&P 500. From 1926 to 2012, U.S. small stocks have delivered compounded annual returns of 11.9% versus 9.8% for large stocks, according to Ibbotson data.

U.S. small caps have handily beaten blue-chip stocks since the financial crisis low in 2009 and are trading at a significant valuation premium relative to their larger peers.

The iShares Russell 2000 ETF (IWM) is currently sporting a price-to-earnings ratio of 28.98 based the latest 12 months' earnings, compared with a P/E ratio of 21.84 for iShares Core S&P 500 ETF (IVV).

IWM is on track for its best year since 2003, when it rallied 47.6%. In fact, the price ratio of the Russell 2000 versus the S&P 500 is at all-time highs.

Small-cap stocks are enjoying multiple tailwinds. First, they are more closely tied to the U.S. economy while large multinationals are more dependent on emerging markets, which have been a mess this year. Also, since 1979, small stocks have tended to outperform large caps during rising rate periods, and Treasury yields are higher this year.

However, a athree-year standard deviation of 17.11% for the Russell 2000 fund versus 12.39% for the S&P 500 ETF is a reminder that small-caps are prone to wider price swings. Small-caps are more volatile than established companies because they have greater risks and are more sensitive to changes in the economy and investor sentiment.

Over the past decade, investors have been rewarded for the extra risk with the 10.7% annualized return of the Morningstar Small Cap Index easily outpacing the 7.6% annualized return of the S&P 500 Index over the past decade.*

Small caps now look pricey relative to larger companies after their strong run, a reversal of what happened during the dot-com boom. In 2000, U.S. large caps were changing hands at a P/E ratio of around 27 based on projected earnings compared with 14 for small-cap stocks. Currently, large caps trade at a P/E ratio of around 15 based on forecasted earnings, while small caps trade at a multiple of about 19 times prospective earnings, according to Morningstar.

The bottom line is that investors should be careful chasing small-cap stocks after their prolonged stretch of outperformance. At the very least, they should be prepared for potentially more volatility than when investing in established, large-cap companies.

Russell 2000

^RUT Chart

^RUT data by YCharts

*Morningstar analyst report on iShares Russell 2000 ETF (IWM) dated Oct. 21, 2013.

DISCLAIMER: All opinions included in this material are as of October 23, 2013 and are subject to change. The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry, among other factors. Investors cannot invest directly in an index. Indexes have no fees. Past performance does not guarantee future results.

null

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!

Markets

DOW 18,053.71 +23.50 0.13%
S&P 500 2,088.77 +6.89 0.33%
NASDAQ 4,806.8590 +33.3870 0.70%

Brokerage Partners

Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs