I received a good question from a client this week that I wanted to share with you. Ed wrote me the following:
“I recently read you don’t like the Russell 2000, but do you ever use it when it’s having a good year?”
This is an excellent question, and I think many people will be interested in my answer since the financial professionals are always telling people to include some small cap stocks in our portfolios.
I have decided that I would like to do more posts about questions from my customers. I often get similar question regarding International Funds, Tech Funds, etc. I’ll be posting similar replies to those questions soon.
As you know, I am a data geek and a logic nerd. The positions I take derive from lots of analysis of data. And I mostly rely on long term data. Any investment can post great results over a short period of time – 3 months, 6 months, 1 year. But if it has inconsistent performance and its long-term performance is not great, I don’t want to bother with it.
The Russell 2000 (small cap stocks) has had some brief shining moments. But compared to large cap funds like the S&P 500, it comes up short in the long run. Let’s look at the data.
If you’ve read my most recent book, Picking the Best Funds for Your 401K, I explain my decision-making process for evaluating funds or any investment. Without a rigid and consistent process to evaluate investments, people are using gut and emotions which rarely work. I am never interested in opinions about investments if they are not backed up by rigorous analysis.
Here are the three main areas that I use to evaluate any investment.
Performance – particularly long-term performance (10 years, 20 years, 30 years).
Consistency and Volatility – Consistency equals predictability.
Conviction – Knowledge and understanding of an investment and why it should perform well keeps you committed to the investment.
Risk is another important consideration, but these three categories address risk in their own ways.
Let’s compare the S&P 500 index funds (large cap stocks) as an investment against the Russell 2000 index funds (small cap stocks) by running through my three key criteria.
Performance
I always want to look at long-term performance. For this analysis, I am going to use performance data for the last 30 years. I am showing each investments returns including dividends. I am interested in total returns. The S&P 500 has typically paid higher dividends than the Russell 2000. Some people have a bias towards stocks that pay higher dividends. I don’t really care. Total returns are all that matter. Stocks that pay higher dividends tend to hold up better in market downturns but that factors into the consistency and volatility category. Stocks paying higher dividends tend to have lower overall returns.
Here are the performance statistics for the two funds over the last 30 years.
If you started in 1995 with $100,000 invested in each fund, you would have ended up with $2,118,000 at the end of 30 years with the S&P 500 and $1,280,000 in the Russell 2000 – or $828,000 more.
The S&P 500 is the clear winner for long term performance.
Consistency & Volatility
In this next view of performance, we want to look at the detailed performance over the 30 years. Did the S&P have big gains in one decade and weaker performance in two decades? This would make me less confident in its performance. I like to look at individual years the same way.
How did the two funds perform during bear market declines? This tells us about volatility.
There is not much difference in performance between large cap and small cap funds in bear markets. The Russell 2000 did better in the dot-com collapse but similar or slightly worse in the other bear markets. There is no real advantage for either in bear markets. They both get crushed.
How about the 30 annual time periods?
When you study the annual data, the annual volatility is similar between the two investments. You can see by the chart that they move together. The Russell 2000’s performance is helped by strong performance in four or five years, so it is a little less consistent.
How about the data prior to 1995? I have less confidence in data going back 40 or 50 years or more particularly with small cap stock classifications. The way small cap stocks are categorized in the 1960s is not the same as it is today. The S&P 500 data is very consistent going back 100 years.
Large cap stocks won big in the 1980s and the 1990s. Small cap stocks had huge gains in the late 1960s and the early 1970s. There was another short time in the 1940s where small cap stocks outperformed. Again, I have the same issue with consistency with small cap stocks.
The S&P 500 is a slight winner when it comes to consistency and volatility.
Ed’s question contained another question – “do you ever use the Russell 2000 when it is having a good year.” I only care about where I think an investment is going and not where it has been. The Russell 2000 does have short-lived hot streaks, but it is too hard to predict for me or to get that timing right consistently. You have to be right most of the time playing this kind of timing game to make it worthwhile.
The performance of the Russell 2000 has lagged big time over the last few years so maybe it is due for some strong years. But I like to play the long game where the odds are in my favor.
Conviction
Understanding an investment leads to more conviction in that investment.
Gold is an example of an investment that I would have no conviction over. Yes, gold does tend to outperform stocks in bear markets, but it performs so much worse most of the time that you are only going to lose by owning gold in the long run. If anyone could accurately predict bear markets, then they could get in and out of gold at the appropriate times but nobody can do this.
The key issue here though is conviction. If you follow gold and the supply and demand story of this commodity, you soon realize that nobody understands what makes gold go up in value or down in value except after the fact. I could come up with some great stories about why gold has been on such a strong run recently, but anyone that tells you they saw it coming is not being honest.
When I have no idea why gold goes up or down, I have no conviction. Gold doesn’t produce any earnings that we can analyze. It doesn’t pay a dividend.
Let’s view our two funds through that same lense. Both the S&P and the Russell 2000 are highly diversified and include some great companies and some mediocre companies. They both produce earnings which we can track, and they both pay dividends (a little higher for the S&P). They both represent stocks that trade on US stock exchanges and both have companies that do business overseas.
The only difference is company size. The S&P 500 contains large cap stocks (bigger companies) and the Russell 2000 contains mostly small cap stocks (smaller companies). The S&P 500 is made up of the biggest and the best companies in the world. The biggest companies are getting bigger and stronger, and it is getting harder for smaller companies to compete against them. Think of Amazon in retail and Google in tech. I am not making any value judgements about this being a good thing or bad thing, but it is hard to see small companies winning many wars in any industry today.
The small companies do have more growth potential because they are small. There will be a big dominant tech company or two that emerge from the Russell 2000 in the next decade, absolutely. But I can’t tell you which one and it is really difficult for one or two stocks to pull up the average of the 2000 stocks in the Russell index. And those winners will become part of the S&P 500 eventually and they will leave the Russell 2000.
The performance statistics help back up my conviction for the S&P 500.
The S&P 500 wins here as well. It is a clean sweep.
The Russell 2000 is not a bad fund. It’s returns over the last 30 years are much better than most other investments. It is just not as good as the S&P 500.
I think you can see now why Warren Buffett says that all individual investors should just buy the S&P 500 and forget about it.
We agree mostly with Mr. Buffett, but we find times when tech funds and higher growth funds have a role to play. And we definitely don’t agree with the “forget about it” part. Buy & Hold is a very costly strategy when you have a tool like our Market Signals to avoid getting crushed in ugly bear markets. Until we created Market Signals, Buy & Hold & Suffer was the only game in town. Now, everyone can get high growth AND loss protection.
We stick with the S&P 500 index funds, and the Nasdaq index funds and things like the Nasdaq 100 (many good funds like the Nasdaq 100 exist). I’m working on a post like this one comparing the S&P 500 to the tech-heavy funds like the Nasdaq.
Send me your questions and I’ll try to include my answer in an upcoming blog post.
Stay Disciplined My Friends,
Phil McAvoy
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
After a positive week in the third week of January, the S&P 500 and the Nasdaq are within 1% of their all-time highs reached in mid-December. The Russell 2000 (small cap) is still well below (-8%) it’s December highs.
The chart below shows us how all three indices have steadily climbed over the last year. The S&P 500 has climbed 25.7% since the beginning of 2024. The Nasdaq has increased 30.7% since January of last year and the Russell is up 12.3%. This is another data point showing why I steer people away from small cap stocks. The Russell 2000 still sits below its peak reached in November of 2021.
If you follow our system, you posted another year of exceptional increases. Just about all investors did very well in 2024. Even Target Date funds which I don’t like posted 15% gains in 2024. But remember that back to back years of 20% gains are very rare.
The markets were pleased to hear that the new administration seems to be proceeding more slowly with their threat of large tariffs.
Interest rates, inflation and recession worries remain the big story for stocks going forward as they have for almost two years. The consensus is that the Fed will only make two rate cuts in 2025 compared earlier expectations of four or more. Inflation has been stuck at around 3% which is above their target of 2% so they are going to be cautious with their rate cutting.
Employment and GDP statistics remain healthy, but most people are expecting lower economic growth in 2025. The market is still betting on a soft landing. Recent earnings reports from the big banks were very strong which is a good sign for the overall economy.
Longer term interest rates have climbed over the last couple of months. The yield curve is now un-inverted with longer term rates now above short-term rates which is a more normal situation. Strangely, interest rates on 10-year Treasury notes are a full point higher than when the Fed started cutting rates over a year ago. Mortgage rates are tied to 10-year Treasuries, and they have climbed as a result.
Net-net, I still expect a volatile and skittish market going forward. My valuation model still has the S&P 500 at 17% overvalued. With high valuations and a very uncertain economic picture moving forward, the markets will continue to overreact to any bad news. The policies of the new administration are another wild card.
We will continue to ignore our emotions and stick to what our models are telling us. You, too, should stick to your long-term strategy.
Stay Disciplined My Friends,
Phil McAvoy
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
Updated: Dec 18, 2024
I originally wrote this update yesterday morning (Dec. 18th) before the significant price decline in the afternoon. I want to comment on yesterday's market reversal before we look at the longer term trends discussed below.
12/18/24 DECLINE
The stock market experienced a sharp decline yesterday afternoon that began right after Fed Chairman Powell announced that there would be fewer rate cuts next year. The Fed is going to be more cautious in their rate cuts going forward because they are concerned about inflation.
The market was expecting more aggressive rate cutting in 2025 so this was seen as a negative surprise. Bond prices fell as well as interest rates increased after the Fed announcement.
The other surprise yesterday afternoon was the political maneuvering that introduced a last minute risk of a government shutdown. The bipartisan agreement recently reached on a short-term spending bill is being revisited based on pressure from the new administration. It is not clear yet whether this is a real risk or just posturing.
TWO YEAR TREND
The stock market has marched steadily higher over the past two years since the bear market bottom in October of 2022. It is easy to lose track of where we were back then and where we are today in comparison. Let’s look at the relative change in the S&P 500, the Nasdaq and the Russell 2000 since October 2022.
The chart below shows us how all three indices have steadily climbed over the last two years. The measure I am using is the relationship of the current price to the previous all-time high reached before the bear market of 2022.
For example, in early October of 2022, the S&P 500 was down about 25% from its previous all-time high reached at the beginning of 2022. In December of 2024 the S&P 500 is now 27% higher than it was at the beginning of 2022 representing a 3-year gain of 27%. The S&P 500 has climbed about 68% off the bottom reached in 2022.
Interestingly, the Nasdaq is now also 27% higher than its peak at the end of 2021. The small cap Russell 2000 index has taken three years to get back to its peak at the end of 2021.
If you have been aggressively invested in the stock market like our customers over the last two years you have experienced exceptional gains. The 2-year increase is 57%. The S&P 500 has steadily gained about 30% in the last year.
This level of increase in the stock market is quite rare historically. Most measures of market valuations indicate that the stock market is overvalued at present due to the large gains in the last couple of years. My valuation model suggests that the S&P 500 is overvalued by about 19% currently. In the last 50 years, the S&P 500 has only had higher valuations one time – in 1999 at the end of the dot-com bubble and before the dot-com crash in the early 2000s.
As I have mentioned previously, valuation is not a good predictor of short-term market direction. It is a good predictor of long-term market prices. Unless AI delivers increases in corporate profitability of 20%, the market will need to correct at some point. The stock market is currently betting that AI will deliver large increases in corporate profits. Time will tell.
In the near term, the stock market is keeping a watchful eye on economic growth and inflation. The market currently is assuming that inflation is stuck at current levels and that interest rates are stuck as well. The consensus is that the Fed will lower interest rates at a slower pace as they are concerned more about inflation than economic growth at present.
Bond prices were expected to rise as interest rates declined but bond prices (inversely related to interest rates) remain stuck at levels that are 20% to 30% below what they were three years ago.
The US continues to outperform all other global economies. GDP growth is stronger in the US and productivity growth is much stronger in the US.
Despite the positive trend in stock prices, we do expect more volatility going forward.
There is a great deal of uncertainty around the economic policies of the new administration, particularly with regard to inflation.
When markets are overvalued, any negative news can cause a steep drop in the markets. If you do not have a strategy to protect your money against losses like our Market Signals system, you need to be prepared to deal with higher levels of volatility in the coming years.
Stay Disciplined My Friends,
Phil McAvoy
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
%20(1).png)
