Every quarter I take a look at the six different stock asset classes to try to get an idea of how they stack up relative to their historical valuations. Small-, mid- and large-cap asset classes, in both value and growth components, have a behavioral history, and when there are extreme discrepancies in pricing relative to earnings, one can try to capitalize on it.

Based on history, large-cap stocks are currently undervalued relative to small- and mid-caps and, within the large-cap asset class, value is slightly undervalued relative to growth.

Before getting to the current data, a bit of history (admittedly not a lot): Going back to the early 1980s, mid-cap stocks have generally traded at about 86% of the price-to-earnings ratio of large-cap stocks. Small-caps have generally traded at about 82% of the large-cap P/E ratio during the same period. The reasons for the P/E discounts are obvious when one factors in the added risk of owning stocks that are smaller in capitalization and somewhat less proven as consistent growers. Few would argue that a large-cap price premium isn’t warranted, and I’ve yet to hear any arguments to suggest otherwise.

In addition to the premium found in large-cap stocks, there has also been a premium multiple placed on growth stocks vs. value stocks – about 1.5 times greater that is consistent within each of the various market-cap styles. In other words, a value stock that is trading at a P/E of 10 would be on par, or fairly valued, with a growth stock trading at 15 times earnings. This also seems logical, since investors have typically paid up for better growth of earnings.

If you believe the historical relationship is accurate and will likely continue, then it’s worth periodically keeping track of how the various asset classes rank, in terms of valuation. When comparing P/Es of the various asset classes, one can either use forward earnings estimates, or trailing earnings. I use both, but because of time constraints, I have used trailing earnings data here that were available for various ETFs (exchange-traded funds) that track the asset classes. This makes the calculations quite simple.

Bigger Is Better

Historic relationships suggest large-caps are undervalued vs. small- and mid-caps.

*As of Aug. 23.

Source: iShares.com

By comparing the P/Es of the stock asset classes and taking into consideration their historical relationships (assuming they are still appropriate), my findings reveal the following:

• Small-caps are overvalued relative to large-caps by approximately 30%.
• Mid-caps are overvalued relative to large-caps by approximately 17%. In the growth vs. value comparison, my findings reveal:
• Large-cap growth is overvalued relative to large-cap value by approximately 5%.
• Mid-cap growth is overvalued relative to mid-cap value by approximately 12%.
• Small-cap growth is undervalued relative to small-cap value by approximately 30%.

In conclusion, large-caps are the most attractive of the three major stock asset classes. And, within the large-cap asset class, large-cap value is slightly undervalued relative to growth.

The style summary shows both mid- and large-cap growth to be slightly overvalued relative to the value components. Also, small-cap growth stocks trade at a significant discount to small-cap value stocks, about 30%.

No one knows if or when these valuations will revert to some sort of a mean. Small- and mid-cap stocks may well remain overvalued relative to large-caps for years (they already have been for an extended period). And no one knows for sure if the history of these relationships can tell us anything about the future. Still, at least to this humble observer, if you want to own stocks, and particularly if you favor indexing, the large-cap story is most compelling.

Those of you who’ve been reading my recent columns know that I’m not particularly inclined to own stocks right now – I’ve loaded up on T-bills and some step-up CDs for many of my clients. Still, if you want to be in stocks and would like to take advantage of the large-cap discount, the easiest way to get exposure is to simply buy the iShares S&P 500/Barra Value (IVE:Amex) and/or iShares S&P 500/Barra Growth (IVW:Amex).