The relative value of small-cap stocks compared to that of large-cap stocks is trading at its lowest point in over two decades.

As the chart below shows, the price ratio between the iShares Russell 2000 ETF (NYSE:IWM) and the SPDR S&P 500 ETF Trust (NYSE:SPY) is at its lowest level since November 2001, and has decreased by more than a third in the last year and a half.

Chart: iShares Russell 2000 ETF (IWM) vs. SPDR S&P 500 ETF Trust (SPY)

Changing Dynamics in Small-cap Valuations

George Bonne, an equity research analyst at MSCI Inc. (NYSE:MSCI), recently provided valuable insights regarding the underperformance of small-cap stocks when compared to their large-cap counterparts.

According to Bonne’s analysis, over the past 15 to 20 years, small-cap stocks have generally exhibited higher price-to-earnings (P/E) ratios than large- and mid-cap stocks. Conversely, they have been more attractively priced in terms of price-to-book (P/B) ratios.

However, a notable shift occurred in late 2021 when small-cap stocks began to display lower forward P/E ratios compared to large-cap stocks. This means that they have started to screen relatively more attractive than large cap, on a P/E basis.

Additionally, the valuation gap between the two indexes, when measured by P/B ratios, has currently reached its widest point since March 2003.

This raises the argument that small-cap stocks may now present compelling valuations, potentially drawing in investors seeking value opportunities.

Caution Amidst Optimism

This restricted elite of stocks has shown an 85% increase year to date, compared to the 11% of the SPY and the negative 3% of the Invesco S&P 500 Equal Weight ETF (NYSE:RSP).

The duration of these valuation differences between small and large-cap stocks remains uncertain, according to Bonne.

The gap may further widen if small-cap stocks face challenges due to high interest rates, or, the current market environment might represent a new norm.

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