Is the market ripe to find double-digit returns in small-cap stocks?

Big tech is cratering, economists are warning of a lost decade in the stock market and the S&P 500 is going nowhere. What can an investor do?

Pull out your magnifying glass. Today we’re looking at small-caps — and why there’s potential in these stocks.

There are two major indices that every investor should know:

• The S&P 500 Index tracks the performance of 500 of the largest US public companies.
• The Russell 2000 Index tracks the performance of 2000 of the smallest companies in the Russell 3000 Index (~3000 of the largest public US companies).

Small-caps are companies with market capitalizations between $300M-$2B. So not your penny stocks, but not your mega-companies either.

Here’s where it gets interesting

The Bank of America recently sent out this chart to clients:

Lol what? We’ll explain.

The chart implies that the lower the forward price-to-earnings multiple — the higher the returns over the next 10 years.

The red arrow points to where we are today. Whenever the P/E multiple is below 10, the Russell 2000 experiences double-digit annualized returns (>10%) over the next 10 years.

At the end of September, we were at a forward P/E multiple of 10.8 — so we’re close.

What makes small-caps so attractive? They are trading at the largest discount compared to large-caps in 20 years.

In the past, small-caps far outperformed during various periods of economic downturns (1979-1983, 1990-1994 and 1999-2014).

The Russell 2000 also has the following qualities:

• There are fewer tech stocks in the Russell 2000 and more financial stocks.
• Companies in the index tend to have more domestic exposure.

Investing in smaller companies is riskier

There’s a lot more junk and speculative stocks in the Russell 2000 than in the S&P 500.

• 24% of US small-caps are losing money, while only 5% of the total US market is losing money.
• The universe of small-cap stocks is also much larger — making it more difficult to find quality stocks.

The iShares Russell 2000 ETF (NYSE:IWM) tracks the returns of the Russell 2000. Investing in the $IWM is a diversified way to get exposure to the smallest stocks. For those with a bit more risk appetite, we have something for you too. Keep reading.