The fact of a high correlation between small caps and large caps is probably a little frustrating to long-only investment managers as it limits diversification benefits. By contrast, for long/short managers, the strong correlation opens up possibilities to profit from the strong trends in the relative performance of the two indexes – and significant risks, as well, if they are caught on the wrong side of the trade.
All of this begs the question: will the S&P 500® continue its post-2014 outperformance or will the Russell 2000 outperform again? The fact that the United States is in the mature phase of an economic expansion argues for a continued large-cap outperformance if equity investors respond to economic expansions as they did during the 1980s and 1990s. What gives us a little bit of pause in that assessment is that small caps outperformed during the 2003-2007 economic expansion, which was admittedly relatively short compared to previous expansions.
Valuation measures such as price-earnings ratio (viewed here as its inverse, the earnings yield), price-to-sales ratio, price-to-book ratio and dividend yields don’t offer a coherent answer. That said, the first of these measures, earnings-yield, strongly suggests that large cap stocks are not overpriced versus small caps as they were around 1999 and 2000 when a 15-year period of small cap outperformance began (Figure 5).
Price-sales ratio has the advantage of being hard to fudge: companies can window dress earnings numbers much more easily than they can revenue statistics. Price-sales ratio, however, has the disadvantage that it does not account for profit margins earned on those revenues. By this measure, the cap between the S&P 500®’s valuation relative to that of the Russell 2000 is nearly as wide as it was in 1999 when a long period of large-cap underperformance began.
Price-to-book and dividend-yields aren’t sending strong signals one way or the other. S&P 500® price-book ratios are heading higher versus Russell 2000 but are nowhere close to the extreme levels in 2000 (Figure 7). The meaning of aggregate book values, however, is questionable and companies can monkey with book-value accounting in all sorts of ways, including how they manage goodwill from acquisitions and account for the value of assets.
One valuation measure that companies really can’t monkey with is dividends. Either they pay them or they don’t. Some sectors may have tendencies to pay higher dividends than others, and certainly large caps tend to pay more than small caps but the gap between the S&P 500® dividend yield and that of the Russell 2000 shows nothing alarming for the moment (Figure 8).
