Do We Need to Worry About Small Cap Underperformance?

Financial analysts have been preoccupied with the concept of market "breadth" in the last year or so.

Even as the stock market recently pushed to new all-time highs, you hear market pundits critical of the "lack of breadth."

What does this mean, and does it matter?

This word's stock market definition is slightly different than the real-world definition. 

In the real world, "breadth" is another word for "width".

In the stock market, it means how many stocks in an index are going up (or down). 

For instance, if you saw a large majority of the stocks in the S&P 500 going higher (say 400), the market would have "good" breadth. If only a few stocks go higher (say 100), it would have "bad" breadth. 

It can also be used to talk about the performance of the different stock market indices.

Several of these are used by investors, with the most common being the S&P 500, the NASDAQ 100, the Dow Jones Industrials Average, and the Russell 2000.

These four indices make up 95% + of the references to the stock market.

The criticism that many market analysts have of the validity of the strength of the current stock market is that some of these indices are underperforming.

Here is the performance of these four indices across the last year…

S&P 500 +21.8%

Dow Jones Industrial Average +13.5%

NASDAQ 100 +49.0%

Russell 2000 +4.1%

This is a significant performance differential between these indices! The Russell 2000 has underperformed the other indices by double digits and the NASDAQ 100 by almost 45%...

How can we have a healthy stock market if not all indices perform strongly?

The Russell 2000 +4% across the last year is a small return. Less than you would have received for owning short-term U.S. government bonds even.

There are some critical distinctions between the indices, meaning this might be less of a concern.

You can break the indices above into two groups – large capitalization and small capitalization.

The average market capitalization of a company on the S&P 500 is $80 billion. The same numbers on the NASDAQ 100 and Dow Jones are $169 billion and $400 billion, respectively.

For the Russell 2000, it is less than $3 billion.

We are discussing VERY different types of companies when discussing these indices.

The TOTAL market capitalization of all of the Russell 2000 companies ($2+ trillion) is less than the market capitalization of either of the two most prominent companies in the world – Apple Inc. (AAPL) and Microsoft Corporation (MSFT).

Look at what we said about the average market capitalization of the Dow Jones components of $400 billion. That would be 20% of the total market capitalization of the Russell 2000.

Another index called the Russell 3000 is meant to capture the broadest indicator of the U.S. stock market. The Russell 2000 is the smallest 2000 of those companies.

If you took the total capitalization of the Russell 2000, it would make up only 7% of the market capitalization of the Russell 3000.

There is data out there that tells us the total revenue and earnings of the entire Russell 2000. These companies do roughly $2 trillion of revenue and $90 billion of net income. Apple makes almost $100 billion of net income just by itself!

This brings up a great point – should we care at all about the underperformance of the Russell 2000?

The reality is that it represents both a tiny percentage of the total market capitalization of the U.S. stock market and earnings.

Sure – it would be great if the small capitalization stocks kept up with the larger ones…

When you look at the numbers, though, these companies' entire market capitalization and earnings are less than that of Apple!

The fact that the health of the U.S. stock market indices – weighted by market capitalization – is driven by these largest capitalization stocks makes economic sense.

We think there are many legitimate reasons to be concerned about the stock market outlook in 2024, but the underperformance of the small-capitalization Russell 2000 index is not one of them in our book….