February 2024 / INVESTMENT INSIGHTS
Is the market broadening?
Will small-caps eventually “show up” for investors?
Key Insights
- Even contrarians are beginning to question whether it’s worth the wait for small‑caps to make their comeback relative to large-caps.
- The overall quality of small-caps has plummeted as many newer firms have chosen to remain private, suggesting reason for caution.
- Nevertheless, small-caps remain extraordinarily cheap relative to large-caps, providing opportunities to careful active investors.
For those who aren’t familiar, two characters in Samuel Beckett’s famous play engage in a conversation while waiting for a third, named Godot. The entire play unfolds, and Godot never arrives.
As for those of us waiting for small-caps to outperform and the valuation spread between small- and large-caps to revert to the mean, are we waiting for Godot?
Within the five minutes it will take you to read this article, I’ll try to convince you both to hate—and to love—U.S. small-caps.
A long wait
The “hate” part shouldn’t be too hard, as relative valuations show that most investors prefer large-caps over small‑caps.1 Who wants to be overweight small-caps when growth is slowing? Conventional wisdom says you should own them during the early phase of the economic cycle, when we are coming out of a recession.
Even contrarians like us are questioning whether it’s worth the wait. Small-caps have been cheap relative to large-caps, but the valuation spread hasn’t reverted in years. On a relative basis, small-caps have gotten cheaper, and cheaper, and cheaper.
There’s a reason why the valuation signal hasn’t worked. It relates to something asset allocators often ignore. I wrote about it in my book Beyond Diversification—What Every Investor Needs to Know About Asset Allocation, published by McGraw Hill, November 2020—the two asset classes have changed over time.
The most unstable sector weight in the S&P 500 Index—the usual proxy for large-caps—has been technology.2 From 6% of the index in 1990, tech reached a peak of 29% in 1999, during the dot-com mania. Then it declined back to a trough of 15% in 2005. With the rise of the Magnificent Seven,3 it now stands at 29% again. (But don’t panic—the tech sector of today is much more profitable than it was in 1999.)
As tech’s weighting in the index has risen, large-caps have become less exposed to cyclical sectors. In November 2007, before the global financial crisis, the financials and energy sectors represented 31% of the index. These two sectors now represent only 17% of the index as of November 2023. Sector weights for industrials and materials have gone down over this period, too.
The opposite has happened with small-caps—they’ve become more cyclical and less tech-heavy. The chart below shows the trend in the relative weights of key sectors for small- versus large-caps since the global financial crisis. (Here I use the S&P 600 Index to represent small-caps, but the picture looks almost identical for the Russell 2000 Index.)
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February 2024 / INVESTMENT INSIGHTS
Sébastien Page is head of Global Multi-Asset and chief investment officer. He is a member of the Asset Allocation Committee, which is responsible for tactical investment decisions across asset allocation portfolios. Sébastien also is a member of the Management Committee of T. Rowe Price Group, Inc.