Wall Street is evolving into a winner-take-all contest
Statistics suggest that the small- and midcap sectors of the stock market are significantly more overvalued than the large-cap sector.
Nearly half the companies in the Russell 2000 index lost money over the past 12 months - 41.5%, to be exact.
Let that settle in a bit. Here we are, more than six years into a robust economic recovery, more than enough time for companies to recover from the last recession. Furthermore, if you overlook the two-month recession that occurred at the beginning of the COVID-19 pandemic, it's been a decade since the last major economic downturn. Why, then, are nearly half of small-cap and midcap companies still losing money?
This dire situation is projected to get only moderately better over the next year. Based on the mean analyst earnings estimate for each of the Russell 2000's RUT companies, 24% of them will lose money over the next 12 months, according to estimates from LSEG.
These statistics suggest that the small- and midcap sectors of the stock market are significantly more overvalued than the large-cap sector. The Russell 2000's trailing 12-month price-to-earnings multiple currently is 37.3, versus 25.2 for the S&P 500 SPX, according to Birinyi Associates. When calculated using forward 12-month forecasted EPS, the difference is 31.6 versus 21.1.
(By the way, don't be fooled by websites that report that the Russell 2000's P/E ratio is much lower. They reach that conclusion by ignoring companies that are losing money. For example, the website for the iShares Russell 2000 ETF IWM is reporting that the index's trailing 12-month P/E is 18.8 - almost exactly half what it actually is.)
Don't conclude from the Russell 2000/S&P 500 comparison that the large-cap sector is undervalued. That's true only in a relative sense. In absolute terms, the S&P 500 is extremely overvalued, as you can see from the table at the bottom of this column. And if the large caps are already that overvalued, the small- and midcap sectors are in "watch out below" territory.
Top-heavy market
There is a distinct possibility that the small-cap and midcap sectors will always have a high percentage of unprofitable companies. That's because the economy has become one in which the largest firms earn the lion's share of corporate profits. One consequence of this winner-take-all market is that the corporations not at the top of the profit ladder are forced to fight over little more than the crumbs.
Consider research conducted by Kathleen Kahle of the University of Arizona and Rene Stulz of Ohio State University. They found that an increasing share of the total income of U.S. publicly traded corporations are being earned by the 100 most profitable firms. In 1975, that share was 48.5%; in 2015, it was 84.2%.
Another consequence of this trend is that it's more important than ever to be choosy when investing in small- and midcap companies. Researchers have found that, in large part because of the trend toward a winner-take-all market, the so-called small-cap effect has disappeared. I'm referring to the tendency that existed for much of the 20th century for smaller stocks to outperform the largest ones. Researchers have found that the only way to resurrect the small-cap effect is to focus on small-cap stocks that are at the quality end of the "quality-versus-junk" spectrum. (My column two weeks ago listed 15 quality small-cap stocks.)
Where other valuation indicators stand
Every month in this space, I include an updated table showing the latest values of 10 valuation indicators with proven track records of predicting the S&P 500's subsequent 10-year return. The table shows how each indicator compares to the range of its past readings - with 100% indicating that it is more bearish than it ever has been, and 0% indicating that it is most bullish. The average of the indicators in the column is 98%.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
-Mark Hulbert
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