The Unseen Factors Making S&P 500 a Frontrunner Over Russell 2000

In the face of a robust 17% increase in the Russell 2000 index during 2023, the valuations of small- and mid-cap companies might seem more appealing than they did the year before. The encouraging performance of these smaller stocks, however, may not tell the full story. Initial data suggested these stocks were available at bargain prices, with Russell 2000 ETF's price-to-earnings (P/E) ratio dropping from 13.3 to 11.8. Yet this assessment excludes loss-making companies, masking the true economic picture.

Understanding True Valuations

When considering companies that didn't turn a profit, the P/E ratio for the Russell 2000 substantially increases to 27.1. This figure changes the narrative considerably, indicating that these stocks might not be as undervalued as one might believe. This perspective is particularly worrying given that earnings growth for these companies is not on an upward trajectory. Even with a strong economy in 2023, many of these businesses reported diminished earnings, with approximately 800 of them in the red for the past twelve months.

The 'Winner-Take-All' Economy Dynamic

The trend of economic concentration in a few dominant entities further complicates the outlook for smaller companies. As larger firms gobble up a bigger portion of the profit pie, the smaller players are left competing for the leftovers. Historical data reveals that the top 100 most profitable companies have markedly increased their share of total earnings since the mid-70s, indicative of an economy where the winners are taking more than ever. This systemic shift is driven by network effects, particularly in technology-heavy industries, rewarding size and market dominance.

Performance Gap Between Russell 2000 and S&P 500

The consequence of these underlying economic shifts is evident in the performance gap between the Russell 2000 and the S&P 500, a disparity which highlights the benefits accruing to large-cap stocks. Over just five years, the Russell 2000 has trailed the S&P 500 by almost 6% annually. With the continuation of the 'winner-take-all' economic model, this gap could widen, rendering the low P/E ratios of smaller stocks misleading as a sign of investment potential.

Economy, Performance, Valuations