A friend sent me the following text yesterday:
“Wait, the Russell 2000 has been crushing the market lately?!”
Confirming that it has, we launched into a conversation about why the Russell 2000 Small-Cap Index is doing so well, why it’s beating the broad market and why it’s also beating the S&P 600 Small-Cap Index, which is a “higher quality” index of small companies.
These are the key points from our conversation.
The Russell 2000 Small-Cap Index Is on Fire
Since the market bottomed back on April 7, the Russell 2000 has rallied 42%, beating the 36% gain of the S&P 500 by six percentage points.
Since August 1, the Russell is up 15.2%, almost seven percentage points more than the 8.3% gain on the S&P 500.
Why the Russell 2000 Is Doing So Well
Part of the reason the Russell 2000 Small-Cap Index is doing so well is that investors have anticipated that the Federal Reserve will cut rates. That expectation was confirmed when the Fed cut by 25bps on September 17.
While things can change, more rate cuts in the coming months appear likely.
The market is currently assessing a 92% probability that the Fed will cut by another 25bps on October 29, and an 80% probability of an additional 25bps cut on December 10.
This is good for small-cap stocks since rate cuts tend to have an outsized benefit for smaller companies, which carry a higher amount of variable-rate debt. The rate on this debt drops immediately when the Fed cuts rates, thereby reducing interest expense and boosting EPS.
Additionally, investors have been embracing higher-risk assets as the market rally continues. That’s driven some of the interest in smaller companies that make up the Russell 2000.
The Russell 2000 Versus the S&P 600 Small-Cap Index
Historically, the S&P 600 Small-Cap Index has outperformed the Russell 2000 Small-Cap Index.
Data from Index Fund Advisors shows that the S&P 600 outperformed the Russell 2000 by 1.8% annually for 20 years from 1994 to 2013. The S&P 600’s average annual gain was 11.1%, versus 9.3% for the Russell 2000.
The S&P 600 has also outperformed over the last decade (+172% versus 162% for the Russell 2000) and the last five years (+76% versus +67% for the Russell 2000).
The reason the S&P 600 outperforms over the long haul is that it’s a “higher quality” index.
It has a profitability screen. Companies must have posted four consecutive quarters of profits and generated earnings in the most recent quarter to be included.
In contrast, the Russell 2000 lacks a fundamental screen. It is simply a collection of 2,000 of the smallest stocks among the Russell 3000 Index, which covers 98% of the U.S. equity market.
Also, the Russell 2000 is rebalanced just once every year, in June. There is a decent amount of speculation and trading around names expected to be added and deleted at this event.
There is no annual reconstitution with the S&P 600, so traders can’t try and game the index all at once. It is rebalanced in March, June, September and December. Additions and deletions are decided by a committee.
Why the Russell 2000 Has Been Beating the S&P 600 Lately
The Russell 2000 has outperformed the S&P 600 over the last three years (+48% vs. +37%), the last 12 months (+14% vs.+5.5%), since April 7 (+42% vs. +33%) and since August 1 (+15.2% vs. 10.8%).
This is despite the fact that there are many more companies in the Russell 2000 (nearly 40% of the index) that are losing money than there are in the S&P 600 Index (roughly 20% of the index).
On the surface, the rate of losers in the Russell 2000 makes it sound like a bad index. But it’s all contextual.
When the broad market is on a tear, investors are willing to take on more risk, and when interest rates are dropping, well, the Russell 2000 really shines.
Its five largest holdings, IonQ (IONQ), Credo Tech (CRDO), Bloom Energy (BE), Kratos Defense & Security (KTOS) and Oklo (OKLO) have posted an average gain of 90% since August 1. Only two of those companies, CRDO and KTOS, have a history of profitability, while BE has just begun to deliver positive EPS.
Meanwhile, the S&P 600’s five largest holdings, SanDisk (SNDK), Sterling Infrastructure (STRL), BorgWarner (BWA), SPX Technologies (SPXC) and InterDigital (IDCC), have posted an average gain of 55% since August 1.
All of these companies, with the exception of SNDK, which just came public in February and has limited data as a public company, have a history of delivering profits.
Also, that average was pulled up significantly by SNDK (+193% since August 1). Remove that stock and the average gain for the top four S&P 600 stocks drops to about 22%.
Where to Find the Best Small-Cap Stocks
While the Russell 2000 has been on a tear lately, it’s not my favorite way to play small caps over the long haul. I still prefer the S&P 600 Small-Cap Index. The data shows it does better for buy-and-hold investors.
For those who prefer individual stock opportunities and potential to vastly outperform both small-cap indices, my Cabot Small-Cap Confidential advisory highlights some of the most promising small-cap names in the market.
You can learn more by clicking here for a rare trial discount today.
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