The stock market has done something unheard of since 2000. Here’s what history says is happening next.

The stock has produced some extremely strong returns during the current market. Since S&P 500 hit a relative low in October 2022, the index went on to produce a total return of around 62% in less than two years. These are some huge returns for investors.

But not all stocks are participating equally in the current bull market. Small-cap stocks, for example, haven’t fared as well as their large-cap counterparts. The S&P 600which measures the performance of about 600 profitable U.S. small-cap companies, has produced a total return of just 33% since the start of the bull market.

But the stock market just did something that suggests the tide may be turning. The dominance of large-caps in the current run could shift to small-caps, and we saw it early in July.

Here’s what happened and what investors can do to take advantage.

Image source: Getty Images.

The great rotation may be just beginning

During July, institutional investors sold shares of S&P 500-leading megacap stocks and bought small-cap stocks instead. The so-called “big roll” led to the S&P 600’s biggest monthly outperformance against the S&P 500 since December 2000, as MorningstarDanny Noonan pointed out.

The S&P 600 rose 10.7% in July, while the S&P 500 climbed just 1.1%. Small-cap stocks rallied in favor as more data pointed to the likelihood of the Federal Reserve cutting interest rates in September. Smaller companies are more susceptible to changes in interest rates than larger ones, so a cut would favor small caps.

The small-cap index outperformed the large-cap S&P 500 by 11.8 percent in December 2000. But that was just the beginning of a much broader rotation away from the big dot-com stocks that had led the stock market higher in 1990s. During 2001, the S&P 600 outperformed the S&P 500 by 18.8 percentage points, rising while large caps declined.

This table details the months in which we have seen the largest large-cap to small-cap turnover peaks since 2000. It also shows the relative performance of the S&P 600 versus the S&P 500 over the following one-, six-, and 12-month periods after the high rotation.

Data source: YCharts.

As you can see, a strong one-month swing often signals the start of a sustained outperformance in small-cap stocks. The average one-year performance of all seven periods studied is 3.1%, and if you remove the two extremes (high and low), the average is still 3%.

Despite a small-cap retreat and a large-cap rebound in August, there’s good reason to believe next year will look more like the historical average than last month. Currently, there are several factors that favor an investment in small caps beyond historical data.

Small caps could be a great investment right now

As mentioned, there is a growing expectation that the Federal Reserve will start cutting interest rates at its next meeting. That could be a major relief for small-cap stocks, which rely more on floating-rate debt to finance their businesses instead of issuing bonds.

As the Fed eases monetary policy, we’ve already seen the US money supply return to growth after more than a year of contraction. Market concentration usually has an inverse correlation with the growth of the money supply. In other words, smaller companies should see higher profits than larger companies as the money supply increases, as more capital becomes available.

Finally, the valuation gap between small and large caps remains extremely high. The forward price of the S&P 600 is around 15.3. By comparison, the S&P 500 is trading for 21.1. While that’s above the peak we saw earlier this year, it’s still one of the biggest valuation gaps we’ve seen since the early 2000s.

Even if you missed the strong performance of small-cap stocks in July, now is still a great opportunity to invest. You can look for individual small-cap companies that show exceptional value but simply invest in an S&P 600 index fund, such as SPDR Portfolio S&P 600 Small Cap ETF (SPSM 0.38%) could work well for investors.

The SPDR ETF has a low expense ratio of just 0.03%. That means you’ll pay just $3 a year for every $10,000 you invest in the fund. While yields deviated somewhat from the S&P 600 benchmark by a few basis points, that worked out in favor of investors.

Tracking error is also a challenge for competing ETFs, as small caps generally have less liquidity than larger stocks. So keeping SPDR ETF expenses low is one of the smartest ways to invest in the sustained rotation from large-cap to small-cap stocks.