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- After a brief pause after the New Year, the S&P 500 and NASDAQ 100 resumed rallying. But the Russell 2000 has slumped 6%.
- We have been enthusiastic cheerleaders for the R2K since November, arguing it is still pricing in a recession even as 2024 recession risks have receded.
- We will favour R2K over the S&P 500.
- R2K earnings are expected to resume growing in 2024, and its forward P/E is within normal ranges – unlike its large-cap cousins that are trading at the highest levels in 15+ years.
- We like adding to R2K positions. Investors can hold R2K via the IWM ETF.
- We stress this is a medium-term patient trade.
Russell 2000 Stumbles But Still Cheap
The Russell 2000 (RTY, R2K) sparkled in December, outrunning the S&P 500 (SPX) and NASDAQ 100 (NDX) by more than 6%. Now? It is down on its large-cap cousins by similar amounts. Has R2K lost its mojo? Or is it settling back into the November range when equities rallied from the late October low (Chart 1)?
We have been enthusiastic cheerleaders for R2K since mid-November largely because it is trading near recession levels relative to SPX.
A Friendly Trend
Looking at the long-term trading relationship between SPX and RTY, the large and small caps have tracked each other closely (Chart 2). Also, RTY tends to underperform during recessions and market downturns, then recover sharply (Chart 3).
The only times that relationship has broken down are in the dot-com frenzy in the late 1990s and over the past two years. That explains the underperformance over the past two years.
- Recession fears that were prevalent during 2022 and much of 2023.
- The enduring rally of the NDX and the magnificent seven that have boosted the SPX.
The recession factor should be a non-issue at this point. The latest GDP print (+3.3%), ongoing labour market strength, plus underlying sentiment all make clear that Fed policy will not engender a recession.
Why There Is Upside
Other factors support a further rally in the R2K.
RTY earnings have also closely tracked SPX earnings over time, but have lagged recently. This shortfall is another key factor in R2K underperforming SPX. Analysts project a 14% increase in RTY earnings in 2024, versus 9% for the SPX. Those projections may be revised in the next month as 4Q earnings come in, but it appears R2K will get a boost from higher earnings. (The strong growth over time in NDX earnings goes far in explaining its performance.)
Unlike the SPX and NDX where forward P/Es are trading at 15-year highs (ex. Covid distortions), RTY is trading within a normal range relative to pre-Covid years. Either SPX and NDX earnings forecasts are likely to be revised upward, or these indices will struggle to rally much more for now.
Note the R2K P/E has mostly traded higher than SPX and NDX. Investors clearly have had faith in smaller caps over time. One cautionary note is the volatility of the R2K forward P/E. Early each year, analysts pencil in aggressive earnings expectations that cause the forward P/E to fall sharply As the year goes on, earnings forecasts tend to be revised downward, causing the P/E to rise.
For now, the important point for us is that R2K forward P/Es are trading in roughly a normal range, suggesting it has more upside in a rally. But the ongoing challenge in trying to forecast R2K earnings is also reason not to expect a frothy rally either.
Another cautionary note is that R2K companies generate considerably smaller net margins than larger caps. This helps explain why R2K is at risk of sharp drops in EPS and price during recessions. For now, net margins are at normal levels.
Where We Stand
Of the three major indices, there is little question that the tech-heavy NDX offers the most attractive technicals and medium-term growth prospects, albeit with some risk of volatility.
We see a good case for the R2K to perform in line with or better than SPX, if the economy remains on a growth trajectory and the labour market healthy. Many factors that hurt smaller caps – e.g., supply chain woes, inflation, labour shortages – are receding. In this environment, smaller caps should be able to rekindle earnings growth.
That said, we do not expect a repeat of the December rally. This is a patient, medium-term trade.
Investors can hold the R2K via the IWM ETF.
- The Magnificent Seven are the tech mega-caps Alphabet (GOOG), Apple (APPL), Amazon (AMZN), META (META), Microsoft (MSFT), Nvidia (NVDA), and Tesla (TSLA). ↑
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.