It's Prime Time for Small-Company Stocks

They're cheap, and profits are rising. If you wait until the economy is strong, you'll miss the best opportunities.

- NELLIE S. HUANG

Small-company stocks are often the canaries in the market’s coal mine. Typically defined as stocks with a market value of less than $10 billion, their prices usually peak and then decline before large-company stock prices do in anticipation of a top in the economic cycle or a rise in interest rates. Similarly, “they tend to outperform early, when it seems like the worst is behind us,” says Sam Stovall, chief investment strategist at CFRA Research.

Lately, the canaries have been quite chirpy. Over the past six months, the Russell 2000, an index of small-cap stocks, gained a robust 9.1%. It led the S&P 500 index for part of that stretch, a good sign, given that the Russell has lagged the big-company benchmark in seven of the past 10 calendar years. (Returns and data are through March 31, unless otherwise noted.)

No one knows, of course, whether that trend will continue. Uncertainty reigns about when the Federal Reserve will pause its cycle of interest rate hikes and what kind of recession, if any, the economy may experience. But you have plenty of other reasons to give small-company stocks a look now.

For starters, they’re cheaper than they’ve been in decades. Compared with the S&P 500, the S&P SmallCap 600 index currently trades at a 36% discount, in terms of price-earnings multiples based on estimated earnings for the year ahead. That P/E is also a 22% discount to small caps’ average P/E since 2005. Large caps, by contrast, trade at a 16% premium to their average P/E since 2005.