With the major averages seemingly making new all time highs on a daily basis (the Russell 2000 Index is up more than 30% in 2013 & the S&P 500 is up more than 23%), concerns about equity market valuations have been heard more frequently over the past 6 months (see my post about billionaires). The Russell and the S&P 500 have returned over 150% and 100% respectively over the last 5 years in a zero rate environment that looks likely to be the norm for the foreseeable future. While small caps make up a much smaller portion of the U.S. stock market (small caps have about 1/10th of assets devoted to U.S. equities), they can be a sign of risk-taking appetite and have led throughout much of the bull market.
The IWM/SPY ratio has rising throughout 2013, and has recently reached its 2011 peak:
I discussed this ratio about a month ago in my Macro Wrap. It has basically been flat over the past month. At the time, I wrote:
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.
What’s the earnings verdict so far? So far, multinationals have continued to pinpoint North America as generally stronger than Europe or Asia. In that sense, small caps, which are more domestically focused, are at an advantage. While retailers have signaled some weakness, most of the economic struggle in the U.S. continues on the low end, while the high end continues to spend.
U.S. small caps continue to be one of the best areas for equity investment in 2013. Watch the IWM / SPY ratio at this pivotal point for a sign of continuation or reversal.