If you haven’t heard, it’s been a tough year for small-cap stocks here and abroad. YTD, the Russell 2000 is down over 5% and the MSCI World Small Cap Index is trailing the broader index. Both indices are down strongly since early March. The Russell 2000 has fallen approximately 9% and its international cousin has fallen approximately 4% over the past two months.
In our hypersensitive media environment, this of course has invited a number of breathless shotgun reactions as to what this means for markets moving forward. A popular conclusion among many pundits centers on the story that the breakdown of small-cap indices relative to the broader indices is a massively negative early warning signal for a major market correction or collapse. In reality, the historical record couldn’t be more different. Looking back at the historical relationship between the Russell 2000 and the S&P 500 (we’ll go with these US indices because they have longer track records), cycle changes back towards large-cap outperformance have actually coincided with bull market activity.
Don’t get us wrong, as we’ve mentioned on these pages before, the S&P 500 is overvalued based on several long-term valuation metrics we like to follow. A US market correction could certainly pop up at any point, and would be a normal part of participating in the equity markets. Looking at the relationship between small-caps and large-caps, however, it’s hard for us to accept the conclusion that the Russell 2000 breakdown of late is the end-all-be-all canary in the coalmine.
Here’s the chart going back to 1978 on Russell relative strength vis-a-vis the S&P 500. The black band represents the +/- 1 standard deviation band around the long-term average.
As we can see above, the Russell 2000 has experienced a sustained period of outperformance since the end of the 1990s. This, in turn, followed a 20-year secular downward trend that began in the early 1980s. What’s interesting about this? The last time the Russell/SPX relative strength chart peeked its head above the +1 standard deviation bar and reversed (beginning the long secular small-cap underperformance trend through the 80s and 90s), the broader US markets were beginning 20-year secular bull market. Conversely, the major trend-reversal towards small-cap outperformance that took place in the late 1990s happened to coincide with the beginning of terribly frustrating secular bear market that was in place from 2000 onward. These trends contradict the conclusions out there that small-cap underperformance means major trouble in the near or intermediate term. We’re definitely not making a prediction that this we’re in the beginning stages of a multi-decade secular bull market. But, we think relying on small-cap stock index reversals as a warning indicator for broad market activity is misguided based on the record over the past 35 to 40 years.
So, what explains the reversal in small-caps? The answer is very simple. After approximately 15 years of sustained outperformance, small-cap stocks have become very expensive relative to their large-cap compatriots. Matter of fact, they’ve become historically overvalued on a relative basis. As of this week, the Russell 2000 is trading at 16x on an EV/EBITDA basis vs. 10.6x for the S&P 500. We’ve looked at the ratio of the Russell valuation to the S&P 500 valuation over time. That ratio is currently 1.5, slightly off the all time peak of 1.53 observed a few weeks ago. Historically, the average ratio between the two multiples is 1.05. The median is 1.05 as well. Standard deviation for the weekly data going back to 1978 is approximately 0.145. Therefore, the ratio of the Russell EV/EBITDA multiple to the S&P 500 multiple is currently a whopping 3.1 standard deviations above the norm. This is a big, big outlier, which suggests that small-caps could and should be relative underperformers for a while. If we use EV to Sales multiples, we see a similar picture. The relationship is over 2 standard deviations above the norm.
Therefore, we believe it’s premature to flip-out about the small-cap breakdown of late. As shown, over the past four decades, Russell underperformance has actually coincided with broader secular bull performance. Whatever the situation, the bigger story seems to be that if you have all your eggs in the small-cap basket, it may be time to start heading back towards the larger-cap space. These secular shifts between small and large cap seem to take place every 15 to 20 years. It looks like we could be on the cusp of one of those major shifts. It doesn’t mean the end of the world is at hand.
