The year was 1972. Television sets were tuned into shows like All in the Family and Hawaii Five-O. Don McLean’s “American Pie” was playing on the radio. President Nixon was engulfed in the Watergate scandal. And the Oakland A’s took down the vaunted Cincinnati Big Red Machine to win the World Series.

Meanwhile, on Wall Street, the Dow Jones closed above the 1,000 mark for the first time. Reaching that psychological milestone had all the market pundits making one bullish forecast after another.

For their part, investors were certainly in a buying mood. They were particularly enamored with the biggest and most popular blue-chips of the day — dubbed the “Nifty Fifty.”

This core group of 50 stocks ran the gamut from consumer products to retail to technology. Some of these names are still around. American Express (NYSE: AXP). Coca-Cola (NYSE: KO). Texas Instruments (NSDQ: TXN).

Others such as Burroughs Corp. (a mainframe computer maker) are now defunct, having reorganized, merged, or simply fallen by the wayside.

In the early 1970s, it was the Nifty Fifty or nothing. Retail investors and institutional traders paid scant attention to smaller stocks that weren’t part of this trendy clique.

After all, this group owned the most dominant brands and boasted the fattest bottom lines. In fact, these stocks delivered sizzling average earnings growth of 30% in 1972. And as a group, they raced ahead 43% that year, double the 19% gain of the S&P 500.

But we all know what happens when investors crowd into a small space with little regard for valuation.

According to Bridgeway Capital Management, the Nifty Fifty ended 1972 with a heated average P/E of 43, versus a tamer 18 for the broader market. In hindsight, the group had become severely overpriced. Shares of companies like Kodak, Xerox, and Sears Roebuck reflected unrealistic growth expectations that were simply not sustainable.

History buffs (and older subscribers) know what happened next. The disastrous bear market crash and recession of 1973-1974 was just around the corner. During this turbulent period, the Dow Jones retreated from 1,000 back to 577, losing approximately 45% of its value. The Nifty Fifty suffered even more.

The selloff was sparked by a confluence of geopolitical and economic factors, not the least of which was uncontrolled inflation (compounded by an OPEC oil embargo) that led to a troubling devaluation in the U.S. dollar.

The period of rising unemployment, high prices, and stifling interest rates (stagflation) that followed was dismal for investors — the Dow Jones didn’t retake the 1,000 level again until 1982.

During the 1970s, stocks eked out a nominal annual gain of just 5%, not enough to keep pace with the 7% annual increase in the prices of consumer goods. Hence equities posted negative real (inflation-adjusted) returns.

You can see why this period is often referred to as a “lost decade.”

Of course, those who bet on oil and gold did much better. As they say, there’s always a bull market somewhere.

But there was an even larger development underway… an inflection point, of sorts.

While the Nifty Fifty crashed hard (many never recovered), value stocks outperformed growth over this time frame by a 2-1 margin.

Even more noticeably, many investors finally awakened to the potential of smaller stocks. After being relegated to second-class status for years, this overlooked asset class finally began to shine.

Between 1975 and 1984, small caps delivered a powerful annualized return of 35% — more than double the 15% average gain of large caps. On a cumulative basis, that’s a spectacular advance of 1,400% in less than a decade.

Buckle up — another big winning streak for the small guys could be taking shape.

A Small-Cap Breakout

There have been plenty of academic inquiries over the years trying to find the root cause of that small-cap surge. Some point to the passage of the Employee Retirement Income Security Act (ERISA) in 1974, which, among other regulatory safeguards, encouraged more diversification in retirement plans.

Others conclude that having been burned by the implosion of the Nifty Fifty, savvy investors began exploring other options and paying more attention to valuation and risk-adjusted returns. There’s nothing quite as impactful as a lesson learned the hard way.

Or maybe small caps were just overdue.

Countless studies have shown smaller stocks to have a small (but measurable) long-term edge over their larger siblings.

Of course, the exact numbers vary depending on the source. Considering the Russell 2000 Index (the main benchmark for small-cap performance) wasn’t even created until 1984, there’s no standardized data for much of the last century.

Still, one widely respected study by Dartmouth Professor Kenneth French concluded that between 1926 and 2021, small caps outran large caps by 12.4% to 11.0% annually.

I’m sure that 1,400% growth spurt skewed the returns a bit. But it’s compelling evidence, nonetheless.

The fact is, both small stocks and large stocks have repeatedly gone on extended multiyear winning streaks — much like the National League (NL) and the American League (AL) in baseball’s All-Star Game.

Lately, the AL has had the upper hand, winning 10 of the past 11 contests. But before that, there was a stretch where the NL reigned victorious 11 straight years and 13 out of 14.

Back and forth.

It’s no secret that large-cap stocks have ruled the roost lately. Specifically, mega-caps worth $1 trillion-plus.

We’ve discussed the concentrated market leadership of the “Magnificent Seven” many times over the past year.

This handful of stocks recently accounted for a disproportionate 35% of the S&P’s return — more than the 200 smallest constituents combined.

After years of market-crushing gains, these seven behemoths recently traded at an average P/E of 50, more than double the S&P norm of 20. Sound familiar?

Now, I’m not necessarily saying to avoid Nvidia (NSDQ: NVDA) and Apple (NSDQ: AAPL). However, Warren Buffet recently made waves by unloading 510 million shares of the latter (about half of Berkshire’s stake).

Rather, it might be time to increase your exposure to small caps.

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