The S&P 500 continues to be one of the best performing major indices in the world. The index is now up more than 25% in 2013, a very impressive performance for an environment characterized by zero interest rates.
While the SPX has been very strong, performance among geographies, sectors, and themes (e.g. large cap vs. small cap) has been much more divergent. Small cap stocks in the U.S. have been even stronger than the SPX. The Russell 2000 is up more than 30% in 2013. In contrast, emerging market stocks have been particularly weak. In fact, EEM, the most widely followed emerging market ETF, is actually down almost 10% this year.
Recently, the outperformance of small cap stocks has shown some signs of reversing. Here is what I wrote in my Macro Wrap on October 1st:
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 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.
Fast forward to today, and the IWM/SPY chart has essentially been rejected at resistance, inching back into its long-term range:
While that rotation has occurred in the past month, the broader market in the U.S. has remained strong, hitting another new all-time high today.
Meanwhile, emerging market stocks have underperformed recently. I discussed the strength of the SPY vs. EEM ratio in this Macro Wrap in early August (read the whole post for a detailed fundamental valuation comparison):
In fact, the SPY / EEM ratio is close to 7 year highs (red line drawn around 4.50) at the moment:
SPY / EEM ratio, Courtesy of Bloomberg
The ratio has been rising, indicating U.S. outperformance, since late 2010 in fact. But it has really picked up the pace in 2013, rising more than 30% year-to-date.
The valuation differential is starting to favor emerging markets. The bad news there seems to be more than priced in on a relative basis. However, psychology is the driver in the short-term. The U.S. overweight has worked for investors this year, so they’re content to stick with it for now. My hunch, though, is that the SPY / EEM ratio above will have a hard time getting through 4.50 unless a more major shift affecting global markets occurs.
While EEM did initially rally vs. the SPY, the recent weakness has brought the SPY/EEM ratio right back up to that important resistance level:
Once again, my expectation is for a turn here, particularly given the widening fundamental valuation gap without commensurate earnings growth to justify it.
In short, over the next 6 months, I’d expect EEM > SPY > IWM on both technicals and fundamentals. Perhaps long EEM / short IWM is the best pair trade. We’ll look for ideas int he options market to try to take advantage.