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It’s been a rough year for small-cap stocks.

Most of the bear market attention has gone to tech stocks and the Nasdaq, but the small caps haven’t fared much better in 2022. From a 52-week high to low, the Russell 2000 index, which tracks the performance of the smallest 2000 equities in the Russell 3000 index, declined 32%. At the same time the Nasdaq declined 34%.

Overall, lower price tags for small cap stocks have always had a way of enticing investors. These days, even lower price tags are translating into cheaper valuations, just at a time when large cap stocks face major obstacles: inflation, rising interest rates and a surging dollar.

While small caps aren’t immune to those forces, they have a history of outshining their larger siblings when those issues are present.

Small Caps Look Cheap

Everyone loves a discount. Assuming the discount isn’t signaling poor quality or that there is worse to come. When the decline in prices started in November of last year, the small cap index was warning of the approaching economic slowdown. The price decline steepened and now the valuation of small caps, as measure by its price-to-earnings ratio (P/E), looks much more attractive versus its history. Typically, the price and valuation of stocks overshoot to the downside before they recover and return to more normal levels. It’s possible the small caps are at such a point now.

Small caps are cheap versus their own history and versus their large cap siblings. There is about a 25% discount to these historic measures priced into the stocks. Who doesn’t love shopping with a 25% discount?

The Russell 2000 usually trades at a pretty steep premium, on a P/E basis, to the S&P 500 given the higher risk and volatility associated with small companies. When comparing the P/Es of these two indices, the premium for the small caps have shrunk to levels not seen since 2008. That’s a rare occurrence.

Graph titled Small caps are on sale vs. large caps.  Shows the ratio of Russell 2000 to S&P 500 on a P/E basis is low vs. history. Starting in 1995 at a level of just above 1.0 peaking between 3.0 and 3.5 in the early 2000’s and again in 2009 and 2020.  Today the ratio is at 1.19. The average has been 1.57 since 1995. Source: Ally Invest, Bloomberg.

Insulated From Inflation and Currency Risks

There is no doubt that inflation is one of the biggest risks for investors these days. Currency risk has also crept on to the wall of worry as the dollar has appreciated. Small caps can be a way to minimize these types of risk.

Small caps have a solid track record of providing consistent returns in an inflationary environment. In every decade since the 1930s, returns of small caps have muscled their way ahead of the average annual rate of CPI (consumer price index, measuring inflation).

Since the middle of the second quarter last year, the dollar is up a whopping 20%. Fast-forward to today, and the rise in the dollar presents a serious threat to second-quarter earnings as many multi-national companies translate the money made overseas into dollars. On the other hand, small caps have very little international sales exposure, making ownership in this asset class a way to cushion your portfolio against currency risk.

A Recovery Play

Depending on where you think the economy is in terms of the current economic slowdown or potential recession, small cap equities could offer a greater boost to portfolio returns versus blue-chip large caps. Historically, the recovery in stocks of all sizes begins before a recession ends. And small-cap shares tend to recover more quickly than large caps. The data between 1953 and 2009 shows that the average return for small caps was about 17% in the second half of a recession, compared to just under 11% for large caps. The outperformance has continued in the year after those recessions ended. Of course, it’s hard to say exactly where we are in the economic cycle right now.

The Bottom Line

Given the changes in the economy and market over the past eight months, investors might want to consider a modest allocation to small-cap companies. While these stocks tend to have higher risk built in via higher valuations, prices have been reduced to levels not seen since the Great Financial Crisis. With a good track record in environments similar to the one we are currently in; small caps could be at or near a turning point.

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Headshot of Lindsey BellLindsey Bell, Ally’s chief markets & money strategist, is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.

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