The S&P 500 and Nasdaq 100 ended 2023 in a bull market. Their price indexes have surpassed their previous 2021 highs and have shown clearly positive trends, even with the recent volatility. However, while the performance of large caps has been strong, smaller companies didn't go anywhere. The Russell 2000 ETF (NYSEARCA: IWM) is unchanged over a year and is not much higher than the low it reached in 2022. Since then, the index has been in a firm trading range, with a decreasing correlation with the S&P 500 ETF (TO SPY). See below:
The performance gap between the two indices is significant and growing. Of course, for investors this probably means one of two potentials. First, the Russell 2000 may be exposed to larger issues that make it a worse investment option than the S&P 500 or discounted due to large financial flows into larger companies. In my opinion, there is truth to both, potentially giving IWM higher long-term upside but a lower short-term risk profile.
Russell 2000 and the “real economy”
Last year, I covered IWM with a neutral outlook, but viewed it more positively than the S&P 500 because I believe money flows disproportionately benefited large-cap stocks relative to stocks small cap. Crucially, due to the scale of passive investments in market cap-weighted ETFs, financial flows are disproportionately toward the largest companies, creating an immense concentration in just a few stocks, namely Apple (AAPL) and Microsoft (MSFT), which appear to be increasing. indiscriminately to their EPS. For example, Apple's market capitalization is greater than Russell 2000 in full.
This is not a bullish argument for IWM, but a bearish view for large-cap ETFs. However, the timing of this issue is vague, as what I call the “concentration bubble” appears to continue to grow despite their higher relative valuations. See their performance ratio below:
This chart gives us an idea of how a buy IWM and buy SPY pair trade would have performed over time. Since last September, when I last covered IWM, this trade has lost money. From a short-term perspective, my view did not hold up. However, taking this long-term view, we can see the relative performance ratio falling back to the key 2000 mark, signaling a potential spike in the relative valuation of the S&P 500 versus the Russell 2000.
According to iShares, IWM has a TTM weighted average “P/E” ratio of 11.7Xcompared to its S&P 500 ETF (IVV) at 25X. However, IWM's yield is 10 basis points lower, giving us an indication that the overall quality of small business earnings may be lower. In fact, approximately 40% of Russell 2000 companies have negative income. Importantly, the iShares website states that “negative P/E ratios are excluded from this calculation”, potentially implying that it does not account for these companies. This explains why other measures place Russell 2000's “P/E” at 27X today.
Thus, for our purposes, IWM is only discounted if we assume that its constituents will see their earnings normalize after the current earnings recession. While Russell 2000 companies have struggled to maintain profitability since 2020, the S&P 500 has generally stagnated, with a EPS unchanged on the last three years. Taking into account inflation and interest rates, it would appear that the S&P 500 should trade at a greater discount due to the lack of EPS growth (especially after inflation); However, the Russell 2000 faces more immediate economic risk between the two.
Historically, the performance of the Russell 2000 index is closely linked to the manufacturing PMI, which measures changes in US industrial activity. See below:
Because IWM owns a greater number of smaller companies, its holdings are less exposed to the global economy (like mega-caps) and more to the local U.S. economy. Even though U.S. GDP has been decent in recent years, the manufacturing sector has faced considerable challenges, primarily due to supply-side inflationary pressures that have not been quickly passed on to buyers. IWM generally rises and falls with PMI.
The PMI is still in contraction today, indicating a slowdown, but is showing positive signs that could lead to improving EPS for IWM's holdings. In my opinion, we are starting to see a lot of the inflationary factors on the supply side having less impact on the economy, to the benefit of these small businesses. However, with rates high and unemployment low, history indicates that economic demand may soon decline. I think this will have a bigger impact on large caps than small caps because larger companies tend to be more consumer oriented. On the other hand, smaller ones are more often business-to-business companies, making them more exposed to cost growth than to fluctuations in demand.
Speaking of which, about 17.5% of IWMs are industrials, compared to just 8.6% of S&P 500 IVV ETFs. IWM also has greater exposure to energy, real estate, materials and financials than the S&P 500, with less exposure to technology. Again, this makes IWM a fund more exposed to cyclical cycles, particularly US-centric changes. Additionally, IWM's high financial exposure may be problematic as its finances will likely consist of regional banks that continue to meaningful face turmoil. As I discussed, my long-term view is that smaller banks will continue to fail, with larger ones buying up their assets, due to a lack of deposit stability and higher property lending in smaller ones. banks. As such, IWM could be exposed to this issue as it could expand in 2024.
IWM Risk and Reward Profile for 2024
IWM's situation today is complicated because its holdings find themselves in a context of profit recession. The ETF is arguably trading at a steep discount due to its holdings' earnings downturn, but that doesn't mean its holdings won't continue to struggle in 2024. Much of IWM's performance in 2024 will depend on what happens in the US economy, because the structure of the US economy has a significant influence on it.
Interestingly, there is a visible correlation between the producer price index/consumer price index ratio and the total return ratio of the S&P 500 and Russell 2000. See below:
Of course, this is a speculative relationship, but it relies on the fundamental difference between the two. For the most part, large companies in the S&P 500 purchase services or goods from smaller companies in the Russell 2000 and then sell those goods to consumers. Thus, the “producer price index” is generally more consistent with Russell 2000 corporate earnings, while the “consumer price index” is more consistent with large business revenues.
In 2020, we saw producer prices rise more quickly as input costs increased due to the closure of many producers of essential raw materials. Initially, this represented a slight advantage for Russell 2000 companies, due to their strong outperformance between mid-2020 and mid-2021. However, because many of these smaller companies are in the middle of the supply chain, they are more likely to absorb the rising costs as companies like Microsoft, Apple, and Tesla disagree with the increases prices from suppliers. At the same time, these big companies can still raise consumer prices.
This is not true in all examples, but it is a bias that shows and partly explains why the manufacturing sector is facing difficulties while the U.S. economy as a whole appears to be doing well. In the future, extremely low unemployment and hawkish Federal Reserve policies typically lead to increased unemployment and lower economic demand for goods and services. In such an example, I would expect the CPI to decline relative to the PPI, as suppliers maintain their contracts while large companies see a moderation or decline in sales to consumers. This isn't necessarily bullish for IWM, but it is when compared to high-valuation companies.
In the future, it may be possible for the U.S. economy to rebound without rising unemployment or falling demand. In this case, I expect IWM to quickly break out of its current level, likely outperforming the S&P 500 due to its valuation gap. Nonetheless, I think the more likely scenario is a slowdown in economic demand, causing the S&P 500 to fall relative to the IWM. In other words, the Russell 2000 Index is primarily discounted in a recession (because its holdings are part of it), while the S&P 500 does not factor in a recession. So while I'm not bullish on IWM, I still believe it is a positive pairs trading opportunity against large- and mega-cap ETFs.
The chart below shows how this pair trades in general made over the past year (assuming daily rebalancing):
It could be a slight bullish indication that the ratio chart has now returned to the 0.3 level that it rebounded from around mid-November.
Overall, I remain neutral on IWM as I believe the risk remains elevated given regional banking issues and the prolonged woes of the US economy. Moreover, given that many of its holdings do not generate a profit, its valuation is not necessarily low, and it is only low if we illogically remove this fact (as the iShares fund data shows ). However, if we assume that all downturns will eventually reverse, we could then see how IWM is much cheaper than IVV or SPY, given that its “P/E” would be very low if there was a recovery profits, while S&P 500 companies did not. experienced a drop in revenue.