Since 2000, the stock market has shown unprecedented movements. History tells us that this will happen next. : The Motley Fool

The S&P 500 stock price index hit record highs one after another in 2024, but not all stocks are participating in the current bull market.

Major high-tech stocks have been the driving force behind the rise in stock prices in the past few years. Recently, innovation by major companies utilizing artificial intelligence (AI) has further boosted stock prices, and this trend is accelerating.

The market anticipates that these innovative companies will achieve significant profit growth over the next few years, and investors are raising stock prices as a result.

However, if you look at certain indicators, you can see that the dominance of major high-tech companies is about to change. Investors may be able to find a perfect investment opportunity from an entirely different stock group.

Stock price-earnings ratio (PER) is one of the valuation indicators most commonly used in investment. This shows how much to pay per dollar of profit for a certain stock. For example, if a company's profit per share for the past year is 1 dollar and the stock price is 20 dollars, PER is 20.

Since stocks are evaluated based on expectations for the future, it is possible to determine whether stock prices are appropriate by looking at forward PER. Forward PER is calculated using earnings for the next year predicted by management and analysts rather than past earnings.

By looking at stocks as a group and comparing their valuation values with past averages, it is possible to determine whether the entire market is overpriced or undervalued. Also, investment opportunities can be identified by comparing PER in one segment of the market and other segments.

Currently, the forward PER difference between the S&P 500 index for large stocks and the S&P 600 index for small-cap stocks is as open as it has been since the beginning of this century. At the time of writing this paper, the predicted PER for the S&P 500 is 21.3, while the S&P 600 is only 13.9. According to Yardeni Research, it was just before the 2001 dot com recession that this gap exceeded 7.

There is no saying that in the near future, there will be another recession or a sharp decline in the market, but it seems that the possibility that the next rise in the market will be driven by small and medium-sized enterprises is increasing.

In the early 2000s, while the S&P 500 index was sluggish, small-cap stocks rose rapidly. And history is about to repeat itself.

Looking at the ultra-long term, small-cap stocks have historically outperformed large stocks. However, there is a cycle in that outperformance. Small-cap stocks underperform at certain periods, and outperform significantly at certain times.

The valuation gap between large and small cap stocks became so large when the S&P 600 brought large returns to investors compared to large stocks.

From the beginning of 2001 to 2005, the S&P 600 generated a total return of 66.7% and an average annual growth rate of 10.8%. In contrast, the S&P 500's total return for the same 5 years was only 2.8%.

Small cap stocks continued to outperform until 2010, which included the Great Recession. The total return for the S&P 600 was 109.2%, while the S&P 500 was 15.1%.

There are several reasons why small-cap stocks have lagged behind large companies in recent years. One is that rising interest rates over the past few years have put pressure on small-cap stocks, which are heavily dependent on debt for growth.

Furthermore, if investors get 5% risk-free returns from government bonds, they will further discount future earnings. This is a double blow to small-cap stocks. Furthermore, due to concerns about the economic downturn in the past few years, the number of investors who prefer larger, more stable companies has increased.

However, small businesses may be slightly freed from high interest rates. The US Federal Open Market Committee (FOMC) is expected to cut interest rates at least once this year. After months of higher-than-expected inflation data, the market believes there is a possibility that the Fed will cut interest rates even faster. Also, concerns about the recession have abated over the past year.

If that happens, it's a great opportunity to invest in small-cap stocks. It is also possible to research individual companies and find the best opportunities among small-cap stocks. Since there is little stock trading among analysts and institutional investors, these companies are not that widely followed, and there is a great opportunity to outperform the entire market.

However, the easiest way to buy small-cap stocks is to use index funds. You can buy the SPDR Portfolio S&P600 Small Cap ETF (NYSEMKT: SPSM). This exchange-traded fund (ETF) is firmly linked to the benchmark index with an expense ratio of only 0.03%.

Another option is an index fund linked to Russell 2000, which is often used as a benchmark for small-cap stocks. Since Russell 2000 does not have profitability requirements like the S&P 600, it includes many growth stocks that are not yet profitable.

The S&P 600 has historically outperformed Russell 2000, but there are also big billionaires who buy Russell 2000 index funds such as the iShares Russell 2000 ETF (NYSEMKT: IWM).

What I personally like about investing in small-cap stocks is the Avantis US Small Cap Value ETF (NYSEMKT: AVUV). Technically, it's an active fund, but it narrows down the small-cap universe using several profitability and valuation criteria, and makes diversified investments into 774 stocks. As a result, most of them are passive portfolios, and fees are kept as low as only 0.25%.

There are large stock positions in any portfolio, but investors should consider using one of the ETFs described above in order to tilt their weight towards small-cap stocks in today's market.