Over the past three and a half years, the S&P 500 has outperformed the Russell 2000 by approximately 70%. This raises two critical, related questions: Can this large-cap outperformance continue, and are small-cap stocks undervalued and poised for a rebound? Historically, both large-cap and small-cap stocks have generated similar returns over extended periods, but their performance cycles differ markedly.
Economic Cycles
The relationship between the Russell 2000 and the S&P 500, while generally highly correlated, has shown significant historical fluctuations that often reflect the broader economic environment.
Late Phases of Economic Recoveries: Large-cap stocks, as represented by the S&P 500, have historically outperformed during the later stages of economic recoveries. This trend was evident in the late 1980s, the late 1990s, and from 2013 until the 2020 pandemic.
- Onset of Economic Expansions and Recessions: Small-cap stocks, as measured by the Russell 2000, tend to perform better at the beginning of economic expansions and during recessions. If the economy were to enter a downturn, the Russell 2000 could potentially become a significant outperformer.
Differences in Valuation Ratios
One of the key reasons to consider a potential shift in market leadership is the substantial variance in valuation ratios between large-cap and small-cap stocks. Currently, the S&P 500 is exhibiting a price-to-sales (P/S) ratio of 3x, while the Russell 2000 is at 1x sales. In terms of book value, the S&P 500 is trading at five times book value, compared to only two times for the Russell 2000. These valuation discrepancies suggest that small-cap stocks are currently undervalued.
Given these valuation metrics and historical performance patterns, the question remains: Will small-cap stocks begin to outperform? The data point to potential outperformance, especially if economic conditions shift.
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