You Don’t Need An Index To Know Which Way The Wind Blows

If there is an investment theme shaping up for Q3 2013, it would appear to be "Go big or go home."  As ConvergEx's Nick Colas notes, that means being maxed out long U.S. stocks, but how broad a net do you cast?  If you only go with the S&P 500, then your July 2013 return was 5.0%.  Not bad, Colas scoffs, until you consider that the small cap universe of U.S. stocks, as measured by the Russell 2000, was up 6.9% this month.  Before you load up on four letter symbols and/or small cap ETFs though, Nick warns that investors should consider that there are several important differences between these alternative universes.  Among the most important (discussed below) are sector weights are very different, with Russell short Energy and Consumer Non-Cyclicals versus S&P; and, the S&P 500 is heavily overweight its top five names (APPL, XOM, JNJ, GE and CVX), which represent 10.7% of the index.  The corresponding weight of the top 5 names in the Russell 2000 (CGSP, ATHN, CVLT, FMER and AYI) is 1.3%. Be sure you know what all-time high you are buying...


Via ConvergEx's Nick Colas,


Pop quiz time: everyone knows the US stock market is on a tear of late, but how much is it up on the year?  Your choices are:









1. 18.2%


 


2. 18.8%


 


3. 21.4%


 


4. I don’t care.  I run a market neutral book.



If the answer is #4, and you are up on the year, well done.  You play in a rough sandbox and deserve a lot of credit.  Among the other choices, all have a case for being the correct answer.  Here’s why:









1. 18.2% is the return of the S&P 500 through the end of July.


 


2. 18.8% is the return of the Wilshire 5000


 


3. 21.4% is the return of the Russell 2000



That disparity in performance between the Russell 2000 and S&P 500 is the subject of a fair bit of scrutiny of late, because until the end of June 2012 these two closely watched indices were pretty much neck-and-neck.  The just ended month of July saw the real breakout for the Russell, up 5.6% on the month, while the S&P 500 managed (just?) a 4.4% return.  Since the former tracks the small capitalization end of U.S. equity markets while the later covers large and super capitalization names, the breakout performance for the Russell seems to have a handful of explanations.  These include:









The U.S. economy may not be growing gangbusters, but it is better than most of the alternatives.  Europe is like a swimmer in the ocean, pummeled by waves and repeatedly trying to reach down on tippy-toe to find a bottom.  To no avail, as of yet.  Japan is running an unprecedented monetary expansion to end decades of deflation.  China...  Well, the old saying about a mystery wrapped in an enigma comes to mind.  Since smaller companies tend to have less overseas exposure, they should fare better than larger multinationals.


 


The U.S. Federal Reserve may talk the taper, but it walks a still-expansionary balance sheet.  That was the message from yesterday’s announcement from the Open Market Committee, and small cap stocks continue to benefit from a ‘Risk on’ investment landscape.


 


Commodity prices are in retreat and labor cost inflation is still low.  These macro trends benefit smaller enterprises with less bargaining power for both these input costs than their larger rivals.


 


Portfolio managers of all stripes want to add stocks which exhibit lower correlations to the market overall.  The current correlation of the Russell 2000 to the S&P 500 is 91.6%, which sounds high until you consider that it was 94.3% last week and 94.7% a month ago, when the breakout for small stocks began to catch its head of steam.


 


The classic “Substitute good” for U.S. small cap stocks is emerging markets equities since both offer faster long term growth than large cap names or developed economies.  To say emerging markets have been doggy investments in 2013 does a disservice to man’s best friend.  The MSCI Emerging Market Index is down over 12% year to date.  That leaves U.S. small caps with the high-beta crown solidly in its grasp.



Breakouts have an odd effect on traders: some want to play the mo-mo trade long, and others just itch to short them once they lose just a little bit of steam.  The rally in the Russell 2000 is drawing both types of attention at the moment.  For me, it is pretty clear that the current rally has plenty of room to run into the light volume days of August.  But I respect the contrarian point of view…


Still, no matter your directional call, consider that the Russell 2000 and the S&P 500 have important differences which don’t get much attention.  Nowhere is the devil in the details more than in index construction.  Consider the following:









The S&P 500 may have lots of names, but like in Animal Farm, some are more equal than others.  Specifically, five stocks have just over 10% (10.7% to be precise) of the weighting in the index.  They are Apple, Exxon Mobil, Johnson & Johnson, General Electric, and Chevron.


 


By contrast, the Russell 2000 has no such dominant names.  The top five stock weightings total just 1.3% and belong to CoStar Group, Athenahealth, CommVault Systems, FirstMerit Corp, and Acuity Brands.


 


Sector weightings are also quite different between the S&P 500 and the Russell 2000.  Energy, for example, is just 5% of the Russell, where is it 11% of the S&P 500.  This is one of the sectors that has held back the large cap index in 2013, with a 15.4% return for the Energy names of the S&P 500 versus the index’s return of 18.2%.


 


Industrials, a sector which has outperformed in 2013, have a greater weighting in the Russell, to the tune of 14% of the index versus 10% for the S&P 500.


 


Consumer non-cyclicals – traditionally a defensive group which underperforms in bull markets – has a 10% weighting in the S&P 500 and only 4% in the Russell.



All this puts the whole discussion about small caps/big caps into a more robust framework.  In the end, there’s no denying that the Russell 2000 has been on a tear and that large caps are struggling to catch up.  At the same time, there’s more to the narrative.  Not only do smaller companies benefit from a relatively stronger U.S. economy than rest-of-world, but the best known index which marks their progress is simply better suited for a cyclical rally.  More industrials and less defensive names, as we’ve shown.


Markets may only move in two dimensions – up/down and through time – but how we measure them has several more facets.  The S&P 500 and Russell 2000 are not directly comparable, even excluding the simple question of market cap focus.  In the end, they will both work their way higher over the short term if current market psychology remains in place.  As for which outperforms in August and beyond…  That is more than just “Small cap” versus “large cap.” 

Sign Up

Get the InvestingChannel
Free e-Letter Today

Learn More

Independent market opinion, analysis and ideas - delivered every business day

Premium market opinions, analysis, and ideas - delivered every business day

Editor's Picks