The relative trailing price-to-earnings (P/E) ratio of the Russell 2000 vs. Russell 1000 indices continues to remain near its 25-year lows, and 32% below its long-term average. Except during the regional banking crisis in early 2023, small-cap relative P/E has only been less expensive in 1998-2000, which was followed by strong small-cap relative P/E expansion. Small-caps also expect stronger earnings growth in 2024, which we believe makes small-caps well positioned to outperform their large-cap counterparts in the periods to come.
Chart is based on the relative price-to-earnings (P/E) ratio. P/E ratios utilized are based on trailing 12-month earnings. Small caps are represented by the Russell 2000 Index, which measures the performance of the 2,000 smaller companies that are included in the Russell 3000 Index, which itself is made up of nearly all U.S. stocks. Large caps are represented by the Russell 1000 Index, a subset of the Russell 3000 Index, and consists of the 1,000 top companies by market capitalization in the U.S. The price-to-earnings (P/E) ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings. Relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period.
Thanks to the COVID relief programs, personal savings soared in 2020 and 2021, peaking at $6.5 trillion (about a 364% increase from historical levels). But over the past two years, those excess savings—which many have credited with helping keep the economy strong—have been spent.
Consumer spending has been slightly up year-over-year (as of July 22, 2023), according to Bank of America credit-card spending data. While spending was significantly down in categories such as online electronics, furniture and gas, consumers have been paying more on dining and entertainment.
In July, the S&P 500 Equal Weight Index and the Russell 2000 Value Index outperformed the S&P 500. But for this year so far, the tech-heavy Russell 1000 has led the way—up 33%.
Small-cap stocks take on more risk than their large-cap counterparts, but for patient long-term investors, that risk may be compensated with outsized returns. Historically, small-cap stocks have averaged a 10.5% return, outperforming their large-cap counterparts by 2.5% on an average annualized basis. This has been mainly driven by their higher growth rates, domestic focus, and smaller size and scale, making them more innovative and nimble, as well as their economically sensitive nature.
Small-cap historical returns show that below-average return periods have been followed by those with above-average returns. Specifically, in periods where the Russell 2000 Index 5 year trailing return has been below the historical average of 10.5%, the forward 5 year return is higher 100% of the time and averages 14.9%.
Not only is timing the markets an impossible feat but could be costly from a returns perspective. As the chart below depicts, once the Russell 2000 troughs, the forward 1-year return is 63.8% but missing just the first five trading days of the recovery decreases your return by 12%, and missing the first month cuts the return in half.
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