Small companies’ stocks endured a punishing month in July, trailing their larger counterparts by the widest margin in nearly five years as investors worry over lofty valuations.

The Russell 2000 index, which measures the performance of US-listed companies with an average market capitalisation of about $1.8bn, fell 6 per cent last month. That compares with the Russell 1000 index, which tracks the large-cap segment of the market and fell 1.6 per cent. The underperformance of small-caps by 4.4 percentage points is the largest amount since October of 2009.

The moves comes after small-caps had notably outperformed the shares of larger groups in 2013. As valuations continued to creep higher, investors have rotated to large-caps that were seen as having more reasonable prices. Areas that enjoyed the biggest gains, such as technology and biotechnology, have been the hardest hit.

“Small-caps have worked so well,” said Steven DeSanctis, a small-cap strategist at Bank of America Merrill Lynch. “Now there is a question mark around paying up for small-caps. People are starting to come to the realisation that small-cap stocks are expensive.”

That includes the Federal Reserve. In July, the Fed said that “equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms”.

With the sell-off, the forward p/e for the Russell 2000 dropped to 17.5 times for the month of July from nearly 20 times in June, according to data from Russell. It still sits above the 10-year average of about 16.5 times.

In the year to date, small-caps are down about 3 per cent following on from a rally of nearly 40 per cent in 2013. They are trailing large-caps by 8.6 percentage points, the most since 1998, a year considered to be among the worst to date for relative performance in small-cap stocks.

“Small-caps have lagged [behind] since the beginning of the year,” said Eric Marshall, co-manager of the Hodges small-cap fund. “Part of that has been the broader market playing catch-up.”

The absence of a major broad-based correction in equities since the summer of 2012 and a sharp drop in the stock market last week has some bears growling that small-caps may be leading the way down. In July, the S&P 500 had its first monthly decline since January.

Barry James, portfolio manager of the James Advantage Funds, said: “The market has been ready for a correction and the first stage of that is that the small-caps typically get hit.”

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