The Magnificent Seven-dominated S&P 500 and the U.S. small-cap benchmark Russell 2000 outperform in wildly different investment environments. As a result, changes in the ratio of the S&P 500 to the Russell 2000 can indicate evolutions in market leadership.
Currently, the relative value of S&P 500 and Russell 2000 imply future underperformance for U.S. large-cap stocks. The recent weakness in Apple stock – it’s down 13 per cent since Dec. 15, and Tesla, lower by 30 per cent for the same period – might be a sign of things to come.
The chart below depicts the level of the S&P 500 divided by the Russell 2000 since 1990. A rising line indicates the large-cap S&P 500 outperformance. The long-term average is 2.02; one standard deviation from the mean – or the average – is 0.35. This means the S&P 500 is one standard deviation expensive relative to the Russell 2000 at 2.37 and two standard deviations extended at 2.72.
In search of market inflection points, I calculated two-year cumulative returns subsequent to the S&P 500 exceeding one standard deviation. For example, from late September, 1990, to late January, 1991, the S&P 500 was more than one standard deviation expensive. For the two years after that, the Russell 2000 returned 64 per cent on average and the S&P 500 returned 33.5 per cent on average. Small caps outperformed.
The rise and fall of the 1990s tech bubble is arguably the most applicable test of the indicative powers of our chart for the current market backdrop. Initially, the S&P 500 was one standard deviation expensive from May to August, 1998. This turns out to be the one time period on the chart where the Russell 2000 failed to outperform in the following two years as the large-cap tech bubble continued to gain steam.
The S&P 500 became two standard deviations expensive relative to small caps in August, 1998 and this remained the case until December, 2000. Two-year subsequent returns for the Russell 2000 averaged 2 per cent while the S&P 500 averaged a 13-per-cent loss for the two years following this period.
The S&P 500 was one standard deviation expensive from February, 2001, to mid-December, 2001, as the tech bubble deflated. The forward two-year returns after this time frame averaged a loss of 3.2 per cent for the Russell 2000 and a loss of 18.2 per cent for the S&P 500.
The S&P 500 exceeded one standard deviation expensive relative to small caps again in September, 2023. It could, like June of 1998, be the beginning of sustained bubble conditions for large caps. However, the longer the S&P 500 remains extended relative to small caps, the more cautious investors should become about the large-cap market rally.