Brea(d)th of Life: Market Leadership Shifts

While the current bull market for the S&P 500 started in October 2022, the same can't be said for the Russell 2000 index of small cap stocks. The latter's bull market started a full year after the former's, given the Russell 2000 didn't take out its June 2022 low until late October 2023. Since then, the Russell 2000 is up about 33%, nearly the same as the S&P 500.

Yet, since the S&P 500's October 12th, 2022 low, it is up nearly 54% while the Russell 2000 is up nearly 30%. Large caps have held a commanding lead over small caps in this cycle—a unique development relative to history, since small caps either kept up with or outperformed large caps in the early stages of prior bull markets. That clearly isn't the case this time, but it's mostly justified. From an interest rate perspective, small caps were under heightened pressure from the Federal Reserve's rate hiking campaign, given their higher share of variable rate debt and lower interest coverage ratios.

Prior to the latest release of the tamer-than-expected consumer price index (CPI) on July 11—which elevated the probability of a September start to rate cuts by the Federal Reserve—large caps were trouncing small caps this year, as shown below. What a difference a couple of weeks makes.

The outperformance of small caps since the CPI report hit an extreme on July 17, when the five-day spread between the Russell 2000 and the S&P 500 hit an all-time high of 10 percentage points.

Bifurcation at the cap level is not the only tale of two markets. There is also the bifurcation at the index level vs. the average member level. As shown below, maximum drawdowns have been mild so far this year at the index level. That's because the mega-caps' outperformance has "flattered" cap-weighted indexes. The real drama has been under the surface at the average member level. An extreme case in point is within the Nasdaq: At the index level, the maximum drawdown is a tepid -7%; however, at the average member level, the maximum drawdown is a whopping -40%. After hitting an all-time high on July 10, the Nasdaq has had a 5% pullback at the index level, with the churn under the surface persisting.

Better performance away from the prior dominance of mega-cap tech and tech-related stocks resulted in a sharp improvement in market breadth. As shown below, for all three major indexes—particularly the Russell 2000—there was an epic surge in the share of each index's constituents trading above their 200-day moving averages.

In addition, as of the end of last week, 75% of the Russell 2000 was trading at a 20-day high. That matched the prior highest reading (December 2023) in more than three decades. From a sector perspective, three out of the S&P 500's 11 sectors, have more than 70% of stocks trading at 20-day highs: Real Estate, Financials, and Utilities. Those sector biases likely represent a combination of rate-cutting optimism (Real Estate and Financials) and a desire for some defensiveness and yield (Utilities). Bringing up the rear are Consumer Discretionary, Healthcare, and Tech, all below 50% in terms of the share of stocks trading at 20-day highs.

A natural question is whether the broadening out has legs. Historically, moves similar to those over the past couple of weeks bode well for a continuation of the bull market. However, history also shows some consolidation is likely near-term; perhaps reflected in some of the retreat in the ratios shown above.

From a factor (characteristic) perspective, the past month has been rewarding to stocks with higher volatility/variability and greater leverage. Volatility and variability factors have gotten a lift courtesy of the strength of prior laggards, also explaining the momentum and size factors being the worst performers over the past month. Better performance by the leverage factor can be traced to the expectation of rate cuts starting in September, establishing an improving backdrop for more indebted companies.

Another under-performing factor over the past month is profitability as investors shifted some attention away from large caps (with generally better profit profiles) to small caps (with generally weaker profit profiles). As shown in the chart below, the year-over-year change in the S&P 500's forward earnings per share (EPS) turned positive late last year. Since then, it has climbed well into double-digit territory, helping underpin the large-cap rally.

It's taken much longer for the Russell 2000's forward EPS to climb over the hill; in fact, it was only a few months ago when its year-over-year growth finally turned positive. Expectations have downshifted again, due to a mix of base effects, the Russell 2000's annual rebalancing, and a pullback in analysts' confidence around earnings.

We have been emphasizing the difficulty of looking at "the market" as a monolith—be it at the large- or small-cap levels. Concentration has made that a difficult exercise for the S&P 500, since nearly 40% of its market cap is made up by just 10 companies. Profitability has made it a difficult exercise for the Russell 2000, since about 40% of members in the index have no earnings on a trailing 12-month basis.

There are ample opportunities within the small cap space, but we would caveat that with a recommendation to stay up in quality, notably by focusing on factors like profitability and high interest coverage ratios. Unfortunately, at the index level, the Russell 2000 is not always going to reflect the strength of those companies. That is evidenced by the fact that profitable companies in the index have been outperforming non-profitable companies by nearly 19% over the past year, as shown below.

Our bias toward profitability is why we often gear investors toward the S&P 600 small cap index as a source for ideas, given it has a profitability filter. Given that, the index has a much tamer forward P/E compared to the Russell 2000's, which is distorted by poor earnings data. It also looks much better relative to the large cap S&P 500, as shown below. The spread between their forward P/Es is near its widest since late 2021 (and before that, mid-2001)—meaning large caps are incredibly expensive relative to small caps.

The valuation discount suggests small caps are attractive relative to large caps, but it doesn't necessarily mean they will outperform in earnest. Case in point: Since the December 2021 peak P/E spread, the S&P 500 has outperformed the S&P 600 by nearly 17%; yet, since the peak spread in December 2000, the S&P 600 is up by 618% while the S&P 500 is up by 278%.

It's premature to assume the broadening out and leadership shifts which have occurred over the past couple of weeks have longer-term legs. The rotation has been driven by profit-taking (following massive profits) in the prior mega-cap winners and a hefty dose of short-covering among the prior laggards. In the case of the latter, it was often the case that short-covering drove higher those market segments which had been long-term underperformers; that in-and-of-itself should not be a cause for concern.

We remain constructive on high-quality small caps, but we use the evidence above to manage investors' expectations when it comes to performance. Using lingo often tied to traders, we would suggest "fading" the lower-quality segments of small caps, while "leaning in" to the higher-quality segments. A significant valuation discount may be supportive for small caps in general, but for now the weaker profitability profile represents a valid explanation. So, although the valuation discount is compelling, it is not necessarily a catalyst for continued outperformance, at least not until the broad earnings profile for small caps turns higher.