Investors should become more enthusiastic about US small-cap stocks when valuations become more compelling. Small-cap valuations today are unusually rich. Our preferred composite P/E ratio indicates the Russell 2000® trades at 33.7 times normalized earnings, about 60% above fair value and in the top 2% of all historical occurrences. Short-term metrics are little more compelling; the trailing P/E ratio (also 33.7) is in the 94th percentile of all observed valuations. Large-cap stocks—while expensive on an absolute basis—seem like bargains in comparison and trade at a 35% to 40% discount to smaller companies depending on whether normalized or trailing earnings are used.

We have advised an underweight to US small-cap stocks for some time, preferring instead US large-cap or high-quality equivalents. High valuations have slightly weighed on US small-cap performance, with the Russell 2000® returning 11.3% over the past 12 months versus 11.9% for the Russell 1000®. More recently, however, small caps have been closing the gap—year-to-date the Russell 2000® has returned 4.0%, or 30 bps more than the Russell 1000®. Small-cap stocks have been buoyed by forecasts that suggest their profit growth will outpace that of large-cap peers in 2015. Bullish investors seem to ignore that estimates have been slashed since the start of the year to just 6%, focusing instead on the greater exposure of small caps to the healthier US domestic economy (over 80% of Russell 2000® revenue is domestic versus between 65% and 70% for the Russell 1000®), the related theme of limited exposure to the stronger dollar, and a relatively low 3% weight in the small-cap index for the ailing energy sector.

Taking these arguments one at a time, while a weak first quarter for US GDP growth has become the norm in recent years, the US economy shrinking by 0.7% to start the year was far worse than expected and compared poorly with stronger numbers from Europe and Japan. Expectations remain high that a second-half recovery will still see the US economy grow by around 2.5% in 2015, but at a minimum the growth differential between the United States and its peers is set to narrow. The dollar, which had been strengthening since the middle of 2014, has been impacted by this weaker data and reversed some of its gains against currencies like the euro in recent weeks. Energy sector earnings are still expected to weigh significantly on large caps, but oil prices have rebounded from earlier lows and large-cap energy sector companies are successfully pushing through significant cost cuts. In addition, the expected bounce in household spending (which was disproportionately expected to benefit small caps) given the windfall from cheaper oil has failed to materialize as Americans seem to be increasing their savings rate.

Sector performance across the Russell 2000® has been uneven and does not suggest all sectors are similarly overvalued. Over the past 12 months, technology (22.6%) and health care (41.2%) stocks have posted massive gains, while sectors like consumer staples (5.7%) and industrials (1.8%) have underperformed. Sector outperformance helps explain the roughly 1,200 bp outperformance of small-cap growth (17.7%) versus value. When this will reverse is anyone’s guess, though in part it will depend on how much longer low interest rates can be used to justify historically low discount rates. Rate increases might buffet small caps from a different angle—according to Barclays, debt/EBITDA for Russell 2000® companies is around 3.5x, roughly 70% higher than that for the Russell 1000® and well above its historical averages.

Putting this all together, relative valuations and fundamentals suggest that investors continue to underweight US small-cap stocks. The combination of earnings growth around 5% and a 1.3% dividend yield may lead some to hope for double-digit returns in 2015, but this assumes multiples don’t compress from historic highs and earnings tailwinds don’t continue to fade. Should a summer swoon befall equity markets, underweighting small caps should also be beneficial given their higher beta and that large-cap returns are likely to be cushioned by higher dividends and share buybacks.

Wade O’Brien is a Managing Director on the Cambridge Associates Global Investment Research team.