Small-cap exchange traded funds (ETFs) have rallied hard after financial downturn, but some observers note that this trajectory won’t last and it is only a matter of time before this asset class cools down.

The Russell 2000 Index is almost 2% shy of its record closing high, reports Jonathan Cheng for The Wall Street Journal. Meanwhile, the Dow Jones Industrial Average and the S&P 500 are still 13% and 16%, respectively, off their record highs. [For Stocks, Smaller Was Better the Past Decade.]

The Russell 2000 has surged 143% from its March 2009 nadir, whereas the Dow has increased 89% and the S&P has gained 95%. [Small-Cap ETFs Follow Slide in Confidence Index.]

Based on price-to-earnings ratios, small companies currently have the widest premium over large-caps since 1979. The Russell 2000 is trading at 18 times its one-year forward projected earnings, which is around 1.3 times the P/E of the market’s largest 200 companies. Valuations have hovered around these levels in 1983 and 2007, and after both occurrences, small-caps started to underperform the mid- and large-cap asset classes.

Still, Bhupinder Singh, small-cap equity strategist at J.P. Morgan, argues that the Russell’s performance illustrates how small-caps were better equipped coming out of a rough economic patch, which shows that this market still has momentum. Mr. DeSanctis of BofA Merrill Lynch comments that small-caps may experience 19% earnings growth for the first quarter, as compared to the 13% to 15% of the S&P. The broad U.S. economic recovery could help small-caps maintain their growth.

Yet an ETF industry strategist this week recommended investors trim small-cap stocks to moderate risk in their equity portfolios. Small caps tend to be more volatile and “appear to be fairly expensive relative to larger companies,” he said.

Vanguard Small-Cap ETF (NYSEArca: VB)

For more information on small-cap companies, visit our small-cap category.

  • iShares Russell 2000 Index Fund (NYSEArca: IWM)
  • Vanguard Small-Cap ETF (NYSEArca: VB)
  • iShares S&P SmallCap 600 (NYSEArca: IJR)

Max Chen contributed to this article.

Full disclosure: Tom Lydon’s clients own VB.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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