With Wall Street celebrating record highs and major indexes flashing multiple overvaluation signals — from extreme concentration to lofty P/E ratios — one corner of the market hasn’t joined the party: small caps.
In fact, these stocks are now trading at their deepest discount to large caps in more than two decades.
According to Bloomberg data, small-cap stocks are priced at their largest relative discount to large caps in at least 25 years.
In terms of book value multiples, large-cap stocks — measured by the Russell 1000 — currently trade at three times the price-to-book ratio of small caps in the Russell 2000.
For context, that premium hovered near zero in the early 2010s.
Book value multiples measure how much investors are willing to pay per dollar of net assets. That means large caps are commanding a steep premium, while small caps remain historically cheap.
This valuation gap isn’t limited to book value.
Morgan Stanley estimates that small caps trade at a 25% discount to large caps based on forward P/E ratios. Research Affiliates pegs the discount even wider at 40% as of late 2024.
“This is a deep discount relative to the historical median level of -5%, standing in the bottom 4th percentile since 1990,” said Que Nguyen, CIO at Research Affiliates.
Mean reversion on the horizon?
Historically, such extreme discounts have often preceded strong small-cap outperformance.
“The potential for mean reversion to narrow the value gap creates an opportunity for small caps to outperform the narrowly focused large-cap indices over the next decade,” Research Affiliates said.
Morgan Stanley shares that view, forecasting that small caps could outperform large caps by 5% annually over the next two years.
Daniel Fang of CFA Associates suggests investors may soon recognize that small caps offer superior value in an overextended market.
“Small-cap stocks have exhibited higher quality, as measured by an average return on assets,” Fang wrote.
“This analysis runs contrary to the views of some investors, who argue that only the weakest companies remain in the small-cap space, while large-cap indices contain higher-quality companies,” he added.
Even without adjusting for valuation spreads, small-cap performance looks overdue for a rebound. The Russell 2000 has now gone more than 910 trading days without setting a new high, marking the third-longest drought on record.
If history is any guide, the next market rotation could be the one where small caps finally catch up.
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