Last October, we saw an incredible setup in a part of the market many investors ignore – small caps.

These stocks were trading at a near-50% discount to their larger peers when I first highlighted the massive value disparity in DailyWealth.

I shared how small caps were likely to outperform as a result. And that’s exactly what’s happened since…

Small caps are up 40% since then. Meanwhile, the S&P 500 Index of large-cap stocks is up just 12% over the same period.

This is starting to close the valuation gap. Today, small caps are trading for the smallest discount to the S&P 500 in more than a year.

Don’t expect this trend to reverse, though. Small-cap stocks have plenty of upside left.

Let me explain…

Markets take turns in the limelight. Large caps will beat out smaller companies for a few years… And then the exact opposite will be true.

After underperforming for most of the last decade, small caps are starting to catch investors’ attention once again.

The small-cap-focused Russell 2000 Index has tripled the return of the S&P 500 since mid-October. That kind of move is closing the valuation gap I highlighted at the time.

We can see this using the price-to-book (P/B) ratio for each sector. It measures how expensive a market is based on its assets.

Today, small caps trade at a 34% discount to large caps based on this measure. That’s the smallest discount in more than a year. Take a look…

You can see the discount has been closing quickly. It moved from a multidecade low to much more normal levels. But the chart also shows that this gap has much more room to close from here.

Take a look at what happened from 2001 to 2007. Small caps went from a 50% discount to the S&P 500 to a discount of less than 10% in 2006, and they hovered there for about a year into 2007. Importantly, they also crushed the S&P 500’s returns over those years…

Small caps were up 92% from the end of 2000 into July 2007. The S&P 500 was up just 31%. That’s massive outperformance in small caps.

We saw another example of this from early March 2009 into July 2011. Small caps rallied 158%, while the S&P 500 was up just 110%.

Now, it’s happening again. Small-cap stocks have tripled the return of large caps since October. But the move is far from over.

If you’re interested in taking advantage of it, the iShares Russell 2000 Fund (IWM) offers a simple way to make the trade. It tracks the benchmark Russell 2000 Index and should move higher as this trend continues.

In short, today’s valuation gap between small caps and their larger peers is closing. But with the discount still at 34%, there’s plenty of upside left in small caps.

Good investing,

— Chris Igou

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Source: Daily Wealth