The big splash in US markets this week came when Tesla officially became the largest ever stock to enter the S&P 500 index, joining as a top 10 member of the US blue-chip benchmark.

Given its colossal market value of more than $600bn, the addition forced a wave of buying of the shares by investors and funds that track the S&P 500 and selling of other stocks that saw their weighting in the index downgraded. In volatile trading, shares in Tesla settled 6 per cent higher on Friday at a record high of $695, extending a rally over the past six months that saw them gain more than 200 per cent.

That eye-catching debut has been cited as further evidence that the current market rally has moved into bubble territory. But investors should also take note of a broader pick-up in sentiment lower down in the market as markets focus on the prospects of an economic recovery in 2021.

Small-caps are widely seen as more sensitive to the economic cycle than large ones and over the past six weeks, the Russell 2000 index of US small-caps has surged 29 per cent. This has propelled US small-caps’ gains beyond those for the S&P 500: the Russell is up 18 per cent year to date versus 15 per cent for blue-chips.

The performance of small-caps looks even better if one starts at the lows of March, with the Russell having climbed 96.5 per cent, outstripping the S&P’s rise of 66 per cent and even eclipsing the technology-dominated Nasdaq 100’s gain of 82 per cent. Notably, investors are taking a more positive of US small-caps than peers elsewhere with the Russell index’s 29 per cent gain over the past six weeks outstripping the MSCI Global small-cap index gain.

“The shift in equity market leadership in favour of small-caps has legs both in the US and globally,” says Francis Gannon, co-chief investment officer at Royce Investment Partners, a small-cap specialist since 1972. “The record of previous economic recoveries shows that small-caps and cyclicals perform very well, and we see no reason why this would change in the current economic environment.”

Bar chart of US and global small-cap shares surge from November showing Small is beautiful for investors

Assessing the future of equity markets after such a strong run is challenging. The very familiar consensus among investors is that the lagging effects of massive monetary and fiscal stimulus will lead to a global economic recovery during the second half of 2021 and into 2022.

But investors should ask whether small-caps have largely run their race and brought forward some of their prospective gains in 2021.

Bank of America’s monthly survey of fund managers found in December that a record 31 per cent of these investors were “long” or overweight small-caps compared with larger companies in their portfolios.

But valuations are still attractive, argues a note this week from UBS Asset Management. It says US small-caps are trading at “one of the largest valuation discounts in history” to large stocks. They calculated that the ratio of share prices to the book value of assets for MSCI World Small-Cap Index constituents was at a 35 per cent discount to developed world large-caps versus a historical average of 18 per cent.

The high yield debt market is another closely watched indicator that influences market sentiment about small-caps. A pronounced drop in interest rates for these companies from their peak in March suggests that investors believe that the number of corporate defaults is likely to decline and credit quality will improve once the pandemic is history.

However, ultimately, sustaining these rising valuations for small-caps will require not only a sharp increase in corporate earnings but also that the increase outpaces already upbeat expectations. On that score, momentum favours small-caps.

In November, the ratio of forecast earnings upgrades versus cuts over the past three months hit its highest level since 2001. It is now above the equivalent measure for large-caps, noted analysts at BofA in a recent report.

Mr Gannon thinks any pullback in small-caps in the near term will provide investors with a good buying opportunity. In past new business cycles, the Russell 2000 has advanced well past its previous peaks. However, the benchmark has only risen 13 per cent from its August 2018 high.

A sustained rise in the share prices of smaller companies would have another important effect: it may well keep the window open for companies listing their shares. Investors have already seen a rush of new public company listings this year. Over time these may grow into the large-caps of the future.

“A stronger economy should favour small and medium-sized business,” says James Paulsen, chief investment strategist of The Leuthold Group. “Further outperformance from small and mid-caps versus the S&P 500 will bolster IPO activity. Companies looking at going public are not looking at the S&P 500.”

Tesla investors who bought into a young and promising company a decade ago, even with a hefty market value, have certainly enjoyed the subsequent ride. Big things usually have smaller beginnings.