There are only 39 more trading days left in 2020, so today we’ll start what will be a regular series through year-end on the topic of positioning portfolios for 2021.
The issue today: which will perform better next year – the S&P 500 or the Russell 2000? Here is our framework for answering that question:
- Russell 2000: currently trades for 34.4x forward 12-month earnings (IBES estimates)
Note: approximately 30% of the Russell is unprofitable, skewing this metric. For reference, the S&P 600 Small Cap Index trades for 17.7x earnings and all companies here have a track record of profitability.
- S&P 500: trades for 20.8x forward 12-month earnings
Verdict: neither the S&P nor the Russell are anything close to statistically “cheap”, but the latter certainly has more room to grow into its valuation if 2021’s US economic recovery can drive incremental profits. Much of the S&P 500 is Big Tech, which we’ve been more cautious on lately precisely because incremental earnings leverage will be harder to achieve off a high 2020 base.
#2: Access to capital
- There is a strong historical linkage between the performance of the Russell and high yield corporate bond spreads (i.e. above Treasury rates of similar duration). Fundamentally this is because so much of the small cap index is unprofitable, as noted. When high yield markets either seize up (think 2008) or simply price in greater risk (1999 – 2003), small cap balance sheets see more pressure and valuations suffer.
- The S&P 500, by contrast, literally requires a company to show consistent profitability before it is added to the index. Also, once a company becomes consistently unprofitable and its market cap declines to trace-element status in the 500, S&P removes it from the index.
That makes this the most important chart around for judging the merits of small caps (high yield corporate bond spreads back to 1997):
Verdict: high yield spreads have further to fall (5 points right now, sub 4 points for much of 2017 – 2019, as shown on the right side of the graph above), another positive for small caps.
#3: Sector/Individual stock weightings
- The Russell is a truly fragmented index. The top 5 names have a combined weighting of just 2.2 percent.
- The S&P 500 is very heavily concentrated. Apple and Microsoft together are 11.9 percent of the index and when you add Amazon, Google and Facebook those 5 names are 22.3 percent.
- The Russell is basically a “Cyclicals + Health Care” index. Financials, Industrials and Consumer Discretionary sectors total 44.1 percent of the 2000, and Health Care is 21.0 percent. Total: 65%.
- In the S&P 500, the same cluster of Cyclicals (Financials, Industrials, Consumer Discretionary minus Amazon) are 25.4 percent of the index. Big Tech, as noted, is almost as large a part of the 500, at 22.3 percent.
Verdict: if you believe the US economy will see reasonable growth next year (3 percent, for example) then small caps have the sector-level leverage to show greater upside earnings surprises and incremental cash flows than the S&P 500. We are in this camp, but if you are not then the S&P 500/large caps are obviously the better place to be.
The sum of these points favors small caps, but we want to highlight one unique feature of the Russell 2000 before we conclude: over the years it has become Health Care-centric in much the same way that the S&P 500 has grown ever more weighted to Technology stocks:
- Over the decade of the 2010’s, Health Care’s weighting in the Russell went from 14.2 percent to 18.2 percent. As mentioned, it is now 21.0 percent.
- That 6.8 point slice of the Russell has come primarily from 2 other sectors: Energy (3 points) and Technology (also 3 points).
- Over the same period, Technology has increased its share of the S&P 500 by about 10 points with most of that coming from Energy.
The reason for Health Care’s creeping takeover of the Russell is, we suspect, simply due to the large amount of capital formation in the space over the last decade relative to other sorts of small-cap US companies. This trend shows no signs of abating in the current environment and along with capital appreciation (the S&P Small Cap Health Care Index is +18 percent over the last year) means the group will likely continue to grow in importance.
Summing up: we believe US small caps offer better cyclical upside from here than large caps, but the secular trend to higher Health Care exposure in the space is worth understanding if your holding period is longer than a year.