Macro Wrap – David Conquers Goliath, $IWM vs. $SPY

by Enis October 1, 2013 7:49 am • Commentary

The third quarter went to the small caps.  In fact, since the market’s May high, the Russell 2000 is up more than 6%, while the S&P 500 is essentially flat.  But the biggest drag on performance for the SPX this year has been the mega-cap stocks.  These are the year-to-date figures for the top 15 components of the index:

YTD change
AAPL -10.40%
XOM -0.60%
MSFT 24.60%
GOOG 23.80%
GE 13.80%
JNJ 23.70%
CVX 12.40%
PG 11.30%
BRK/B 26.50%
WFC 20.90%
JPM 17.60%
IBM -3.30%
PFE 14.50%
T 0.30%
BAC 18.90%

The average return on the year for these 15 stocks is 12.9%, a far cry from the 17.9% return on the S&P 500 index overall.  Considering that these mega-caps make up around 24% of the S&P 500 index weighting, the other 485 stocks in the index are up more than 20% on average.

That performance gap between large caps and small caps has been widening since April.  Dan noted that the ratio of IWM / SPY was near its all-time high in his Name That Trade post on Friday.

The rotation by fund managers out of the mega-cap stocks and into small cap stocks has actually been a long-term trend.  Here is the chart of the ratio since the start of 2002:

IWM / SPY daily ratio, Courtesy of Bloomberg
IWM / SPY weekly ratio, Courtesy of Bloomberg

I’m curious whether small cap stocks are still in the middle of a long-term outperformance trend vs. large cap stocks, or whether the valuation gap has become extended enough that the contrarian bet makes sense here.  Depending on the bottom-up estimates, the Russell 2000 is now valued about 7-10 P/E multiple points higher than the S&P 500 (22-25x for the Russell vs. around 15x for the SPX).  That doesn’t seem like an egregious gap, but these are small cap stocks after all, not the global stalwarts that dominate the S&P 500’s performance.

Whether we’re in the middle or the end of this trend likely has implications for overall investor appetite as well.  David’s been stomping all over Goliath for more than a decade now.  For now, this is a market where it has paid to be little.