The Russell 2000’s poor performance is one of the key items that has the bears growling lately.
The small-cap stock index is up a mere 1.1% ytd through Tuesday’s close compared to the S&P 500’s 9.5% gain ytd. Likewise, the Russell 2000 is off 5.4% from its July high, while the S&P 500 is only 1.1% off its highest level (Fig. 1).
The underperformance of small-cap stocks can sometimes foreshadow an economic downturn. But the Russell 2000’s lackluster returns may have less to do with economics and more to do with politics and sector weightings.
The Russell 2000 rallied 13.6% in the wake of President Trump’s election through yearend 2016 on hopes that the new administration would push through tax cuts. Many small-cap stocks are domestically focused and have higher tax rates than large, international companies that can shelter their earnings in jurisdictions with low tax rates. Over the same period, the S&P 500 rallied only 4.6% and the Russell 1000 rallied 4.8%.
The P/E on small-cap stocks rose sharply—roughly three points—from the election into early December. Conversely, the multiple on large-cap stocks rose by only 0.7 point (Fig. 2). As 2017 ensued, and the debate over healthcare reform derailed any quick reduction to tax rates, the gains in small-cap stocks stalled.
The underperformance of the Russell 2000 can also be attributed to its sector weightings, which differ from the sector weightings in the S&P 500 in some very important ways. For example, the Russell 2000 had a 14.1% weighting of Technology stocks as of June 30. That’s far less than the 23.3% weighting of Tech in the S&P 500 (Fig. 3). Tech has been the S&P 500’s top-performing sector, returning 23.0% ytd. So the Russell’s lower exposure to Tech would weigh on the index’s returns.
Another big difference in the sector weightings is in the Financials sector. The Russell 2000 has a 26.3% weighting to Financials, while the S&P 500 has a 14.5% weighting (Fig. 4). Being more exposed to Financials may be deleterious to the Russell as the S&P 500 Financials have underperformed, returning only 6.3% ytd, below the S&P 500’s 9.5% ytd return.
There are a couple of other differences between the two indexes, but they are much more minor. The S&P 500 has more exposure to Consumer Staples (8.7%) than the Russell 2000 does (2.4%), and there’s no break-out for Telecommunications or Real Estate in the Russell 2000, but they do have 2.2% and 2.9% weightings, respectively, in the S&P 500. The S&P 500 Telecom sector has lost 10.3% ytd, but the Real Estate sector has gained 4.8% and Staples is up 7.1%.
If tax reform had returned to the front burner and if the Russell had more exposure to Tech and less to Financials, the index would be having a better year and bears would have less to growl about.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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