The stock market is doing something unseen since 2000. History says it happens next.

of S&P 500 has set a fresh new all-time high in 2024, but not every stock has participated during the current bull market.

Over the past few years, large tech stocks have been the driving force behind the rising value of the stock market. This trend has accelerated recently as innovations among the biggest companies using artificial intelligence (AI) have pushed their share prices even higher.

The market expects these innovators to produce massive earnings growth over the coming years, and investors have raised their valuations as a result.

But one indicator suggests that big tech’s dominance may be about to shift. Investors can find a great investment opportunity from a completely different set of stocks.

A huge valuation gap that cannot be ignored

One of the most commonly used valuation metrics in investing is the price-earnings (P/E) ratio. It tells you how much you will pay per dollar of earnings for any given stock. For example, if a company generated $1 in earnings per share last year and its stock price is $20, it has a P/E ratio of 20.

Since stocks are valued based on future expectations, looking at the forward P/E can be a better indicator of whether a stock is fairly priced. Forward P/E uses management’s or analysts’ expectations of earnings over the next year to calculate the ratio, rather than past earnings.

Looking at stocks as a group and comparing their valuation to historical averages can help determine whether the market as a whole is overvalued or undervalued. And comparing the P/E of one market segment to another can help identify investment opportunities.

Currently, the gap between the forward P/E ratios of the large-cap and small-cap S&P 500 index S&P 600 the index is as extensive as it has been since the turn of the century. As of this writing, the S&P 500 has a forward P/E of 21.3, while the S&P 600 sits at just 13.9. The last time the gap reached seven was just before the dot-com recession of 2001, according to Yardeni Research.

I’m not suggesting we’re headed for another recession or a major market downturn in the near future, but it seems increasingly likely that the next step in the market will be driven by smaller companies.

As the S&P 500 struggled to make any gains in the early 2000s, small caps zoomed. And history can repeat itself.

Massive small cap performance

Over a very long period, small caps historically outperform large caps. But this high performance comes in cycles. Small caps underperform in some periods and then massively outperform in others.

The last time the valuation gap between large-cap and small-cap stocks was this wide, the S&P 600 continued to generate huge returns for investors relative to its large-cap counterpart.

From the beginning of 2001 to 2005, the S&P 600 produced a total return of 66.7%, or a compound annual growth rate of 10.8%. By comparison, the S&P 500 only delivered a total return of 2.8% over the same five-year period.

During 2010, which included the Great Recession, small caps continued to outperform. The S&P 600 produced a total return of 109.2% versus 15.1% for the S&P 500.

Data from YCharts.

How to invest in today’s market

There are several reasons why small-cap stocks have lagged behind larger companies in recent history. First, higher interest rates in recent years have put pressure on small caps that rely heavily on debt for growth.

Furthermore, investors will discount future earnings more if they can get a 5% risk-free return on Treasury bonds. This is a double whammy for small caps. Furthermore, recession fears over the past two years pushed more investors to favor larger, more stable companies.

But smaller companies can be positioned to get some relief from high interest rates. The Federal Open Market Committee expects to cut interest rates at least once this year. After months of better-than-expected inflation data, the market thinks the Fed may cut rates even sooner. And recession fears have eased over the past year as well.

This can make it a great time to invest in small-cap stocks. You can research individual companies to find the best opportunities among smaller stocks. These companies aren’t as widely followed — fewer analysts and institutional investors are buying and selling the stock — and that means there’s an excellent opportunity to outperform the overall market.

But the easiest way to buy small caps is to use an index fund. You can buy Small Cap SPDR S&P 600 ETF Portfolio (SPSM 0.98%). This exchange-traded fund (ETF) does a good job of closely tracking the benchmark index with an expense ratio of just 0.03%.

Another option is an index fund that tracks the Russell 2000, which is often used as a benchmark for small-cap stocks. It doesn’t have any profitability requirements like the S&P 600, so it includes many more growth stocks that haven’t yet turned profitable.

While the S&P 600 has historically outperformed the Russell 2000, some big-name billionaires are buying Russell 2000 index funds like iShares Russell 2000 ETF (IWM 1.17%).

My personal favorite way to invest in small-cap stocks is with Avantis US Small Cap Value ETF (AVUV 0.65%). Technically an active fund, it uses several profitability and valuation criteria to narrow the universe of small-cap stocks and weight investments across 774 stocks. The result is a mostly passive portfolio that still keeps fees low at just 0.25%.

While there is still a place for large caps in any portfolio, investors may want to consider using one of the ETFs above to tilt their weighting toward small caps in today’s market.