Russell 2000: Small Companies as the Engine of Job Growth

‘Tis the season for stock rotations.  Stock market sectors tend to fall in and out of favor with regularity, shifting price patterns more often than well-diversified indexes.  Indexes, too, see rotations, especially when there are significant differences among their underlying composition of companies.  And, depending on which scenario one favors for the U.S. and global economies – expanding or contracting growth -- signs are that the second half of 2017 might see turbulence in how the major indexes perform relative to each other –  extracting from the general trend in U.S. equities.  To illustrate the differences, we compare and contrast three key indexes for U.S. stocks – the Russell 2000, S&P500®, and Nasdaq 100.

The first key difference in them is company size.  Both the S&P500® and Nasdaq 100 are composed of publicly-traded companies with large market capitalization, while the Russell 2000 is designed to track small-capitalized companies.  The largest companies in the Nasdaq 100 and S&P500® are mega-stocks with familiar names, such as Apple, Microsoft, Amazon, Facebook, and Alphabet, the holding company of Google, with market capitalization in the hundreds of billions of dollars.  It is, of course, a very different story for the Russell 2000, with the largest company in the index valued at just over $5 billion, and the average company valued closer to $1 billion.  While not exactly household names, the three largest companies in the Russell 2000 – Kite Pharma, Gramercy Property REIT Trust, and MKS Instruments – do provide a flavor for the different businesses represented at the top of the Russell 2000, an index of small companies.

The role of small versus large companies in the economy is not necessarily intuitive.  The most important observation is that small companies, on net and on average and over time, are the engines of job creation in the United States, not the big companies.  Hence, the relatively robust pace of private sector job creation in the U.S. since the throes of the Great Recession in late 2009 is a signal that small companies remain highly confident in the future of the U.S. economy.

Index construction methods are at considerable variance to each other.  The definitions and methods used to create significant differences in their sector weightings imply strikingly different risks.

The S&P500® is “managed” with a disciplined process to determine the approximate relative weight of each sector and to select the stocks for each sector so as to be broad-based and diversified.  So, while the S&P500® is all about large companies, it is not actually a strict representation of the 500 largest companies by market capitalization but a more stylized interpretation of the U.S. economy.    Information technology makes up 22% of the index, with key sectors like financials at 15%, health care at 15%, and consumer discretionary at 12%.  Energy makes up just 6%.

The NASDAQ 100 is not a “managed” index and is not diversified as much as other indexes. By definition, it computationally represents the 100 largest non-financial companies by market capitalization listed on the NASDAQ stock exchange.  There is no attempt in the NASDAQ 100 to be broad-based as it is a stock-exchange-specific index.  Technology dominates, with the sector’s share at just over 50%, followed by consumer services at about 25% (includes Amazon), and health care at 11%.  Financials, energy, basic materials, and utilities are totally absent.  If you like these latter sectors, look elsewhere.

Like the S&P500®, the Russell 2000 is more broad-based, reflecting the natural diversity in the U.S. economy.   FTSE-Russell that created this index calculates the market capitalization of the 10,000 or so public companies in the U.S.  Of the top 3,000 companies by size, the largest 1,000 are in the Russell 1000 and the next 2000 are in the Russell 2000.  The Russell 3000 is the sum of the large and small company indexes.  For the smaller-company Russell 2000 index, financials at 18% and information technology at 17% are the two largest sectors, followed by health care (15%), industrials (15%) and consumer discretionary (12%).   [Note that sector weights are based on market capitalization and are a moving target as stock values fluctuate.  These weights were approximations from July 2017.]

The investment implications of the different sector weightings are that with the Russell 2000 one is getting a broad-based view of the engines of job growth in the U.S. economy.   With the NASDAQ 100, the heavy emphasis is on U.S.-based mega-technology stocks with huge international sales and operations.  This makes the Russell 2000 an important diversification alternative from the tech-heavy NASDAQ 100.  If you are a fan of technology, then NASDAQ 100 is your index.  If the robustness of U.S. job expansion is your theme, then the Russell 2000 is your index.

Indeed, in the first-half of 2017, mega-tech stocks did exceptionally well; the NASDAQ 100 out-performed both the S&P500® and the Russell 2000.  The ability of extremely large technology companies (plus Amazon, in the consumer services sector) to continue to act like high-growth companies is open to debate as (1) they reach relatively mature stages of their evolution, (2) increasingly compete more directly with each other, and (3) face a relatively modestly expanding global economy without a strong engine of growth.  And, in the summer of 2017, there has been more choppiness in the stock prices of these large mega-tech companies, signaling there is a real tug of war among investors with distinctly different views on the sustainability of earnings growth rates.  By contrast, the Russell 2000, which lagged in the January-May 2017 period, picked up some steam in June before seeing some ups and downs in July.

From a scenario perspective, a sustained 2% U.S. economic growth rate and a cautious Federal Reserve, even if raising rates incrementally, have provided a good backdrop for equities.  The global scene may be where many of the risk management challenges are arising – especially in the area of trade pacts, with the U.S. withdrawing from its leadership role.  U.S.-based, large multinational companies are going to be faced with critical decisions if Europe and Japan create their own trade deal without the U.S.; if Asian countries power ahead on a Trans-Pacific trade agreement excluding the U.S., and the if the U.S. fails to get the new agreement it is seeking with Canada and Mexico (i.e., renegotiating NAFTA).   While some small companies do have material international sales, it is expected that should the U.S. be left out of new trade deals, large companies will suffer more than smaller ones.

There is also the uncertainty about U.S. tax policy to consider.   Large companies, especially some of the mega-capitalized ones, hold considerable cash, much of which is outside the U.S.  It was generally thought that with the November 2016 U.S. election delivering a Republican-controlled White House, Senate, and House of Representatives, tax cuts were highly likely and that the Washington political gridlock would be diminished.  Many observers of the Washington scene, however, are now reconsidering these assumptions.  A big corporate tax cut seems much less likely than it did back in January 2017.  Also, the probabilities of a border tax, which would have hurt big-box and on-line retailers, have been mostly eliminated.  The border tax that had featured prominently in the original tax plan circulating in the House of Representatives is now nearly dead as different factions within the Republican Party debate how to craft tax legislation they can agree on.  As in the case of trade uncertainty, the NASDAQ 100 would appear to be relatively more vulnerable to a reassessment of the probabilities of a major corporate tax cut, compared to the Russell 2000 index.

Fluctuation in the oil price could represent interesting risk differences, too, since the NASDAQ 100 has zero energy stocks.  We note, though, that both the Russell 2000 and the S&P500® have only small weightings for the energy sector.  Typically, lower oil prices only depress the S&P500® if the decline in energy stocks is severe enough to impact the earnings of large financial companies that lend to this sector.  This was true when the oil price collapsed in late 2014 and continued into 2015, but now as oil trades in a more defined, if wide, range, the ups and downs of the oil price have not been a distinguishing factor among the indexes.

Turning to another aspect of relative risk, the observed price volatility of the three indexes is no longer all that different.  Back in the 1990s, when technology stocks were coming into their own, the NASDAQ 100 was significantly more volatile than it is today.  Indeed, the Russell 2000 is modestly more volatile than both the NASDAQ 100 and the S&P500®; however, all three indexes have experienced very low volatility in 2017 when compared historically

Interestingly, the sensitivity to interest rates and bond yields is not particularly strong or different among the three indexes, even though the NASDAQ 100 does not contain any financial stocks.   The lack of interest-rate sensitivity is probably more a reflection of the low inflation rate and a very cautious Fed, rather than anything to do with the debt levels or capital structure of the companies in these indexes.  We do note that the Fed’s low-rate and asset-purchase programs, now being slowly reversed, probably benefited the stock prices of large companies much more than smaller companies.  The big guys were better positioned to re-arrange their balance sheets, buy back their own stock, and raise dividends, all of which help valuations, even if doing little to nothing for the economy.

All in all, investors seeking broader diversification in stocks may well consider raising their relative exposure to small-company stocks such as those included in the Russell 2000, given uncertainties from trade and taxes, as well as questions about the earnings growth potential of the mega-capitalized companies included in the large-company indexes.  Investors looking at momentum measures will be weighing the strong performance of the NASDAQ 100, driven in large part by just five huge companies, in the January-May 2017 period; and trying to decide whether that upward price momentum can work through the choppiness of the summer and carry into the second half of the year.  The markets will soon decide which path is the better one.