MGC - IWM: Long Small Caps Short Mega Caps As The 'Concentration Bubble' Unwinds

2023-09-18 09:24:41 ET

Summary

• Mega cap stocks have significantly outperformed small cap stocks over the past decade, with a 10-year total return of 227% compared to 99% for small caps.
• The concentration of ETFs in mega-cap stocks has likely created a positive feedback loop that has pushed their valuations to extremes.
• The Russell 2000 ETF IWM appears undervalued compared to mega-cap stocks and has the potential to outperform the S&P 500 over the next five to ten years.
• An economic recession could hamper IWM's absolute performance, but this can be hedged by pair trading it against a large or mega-cap ETF like SPY or MGC.

Over the past decade, stock market performance has been substantially skewed toward larger capitalization companies. The current ten-year total return for the Vanguard Mega Cap ETF ( MGC ) is 227%, while it is only 99% for the iShares Russell 2000 ETF ( IWM ). The S&P 500 is similar to mega caps at ~220% over the past ten years. Over this period, mega caps have returned around 12.6% annualized while only 7.1% for small caps - roughly equal to the historical average for stocks over the past century. Since January 2020, the Mega Cap ETF has delivered 49% in total returns (11.25% annually), while the Russell 2000 has only risen by ~16% (~4% annually).

Clearly, some trend is pushing Mega Cap performance that is not impacting smaller equities. The discrepancy is not apparent in their fundamentals. The Mega Cap ETF MGC currently has a TTM weighted-average "P/E" of ~24X at an 18% five-year annualized EPS growth rate. The Russell 2000 ETF IWM has a weighted average "P/E" of ~11X . While iShares does not publish its constituent's EPS growth rate, it is 16.6% for the equivalent Vanguard Russell 2000 ETF . Although the five-year historical EPS growth rate is slightly higher for MGC, that does not clearly explain the massive valuation gap. For example, if we extrapolate EPS growth at the same rates for both ETFs for three years, the "three years ahead" "P/E" valuation for MGC would be ~14.6X and 7X for IWM.

Further, from a discounted cash-flow standpoint, MGC is subject to greater cash-flow discounting devaluation due to the rise in interest rates, more so than IWM. As we saw in 2022, higher interest rates usually upset the prices of high-valuation stocks much more than low-valuation ones, such as those in IWM. However, both ETFs had a negative performance of around 20% in 2022; however, IWM has maintained its discount while MGC has recovered despite the continued increase in interest rates.

Those who follow my research likely know I am extremely bearish on mega-cap stocks, particularly mega-cap growth stocks , due to their immense valuation growth. Since small caps and large caps have been in a "see-saw" relationship for some time, the bearish potential for the most expensive stocks may finally lift the valuations for smaller capitalization firms. Of course, while IWM appears extremely cheap, negative economic trends could weigh on its fundamentals. So, we must gauge the macroeconomic outlook and IWM's exposures to discern if it is appropriately discounted for potential earnings trends.

The "ETF Concentration Bubble" Is Ending

To me, it appears that these companies (such as Apple) are rising due to momentum created from excess ETF concentration. Essentially, because almost all ETFs are market-capitalization weighted, stocks with high market capitalizations will naturally see more significant inflows from ETFs as they rebalance, creating a positive feedback loop that can push valuations to extremes. Today, this trend has reached such an extreme that half of the Technology Select Sector SPDR ETF ( XLK ) is just two stocks, Apple ( AAPL ) and Microsoft ( MSFT ). Of course, while this trend may continue for some time, I expect it will end very poorly for many investors because, should the mega-caps begin to fall, the opposite pattern should arise as ETFs automatically rebalance away from these firms, creating an adverse feedback loop.

Going back at least 30 years, we can see a very interesting pattern between large caps in the S&P 500 and small caps in the Russell 2000. During the end of the 1990s, when the first technology bubble occurred, small caps underperformed dramatically. As the bubble popped and value stocks returned in vogue in the 2000s, small caps' total performance was strong enough to erase all underperformance created in the 1990s. Since ~2012, the market has looked more like it did in the 1990s, with larger companies seeing massive inflows while small caps fall by the wayside.

Today, most of the "recovery" in small caps from the 2000s has reversed, with the total performance ratio nearing 2000 minimum levels (or when the "Dot.com" bubble peaked). Assuming this pattern will continue, we can expect around 40-60% in outperformance from IWM compared to the S&P 500 over the coming five to ten years. Of course, that is merely based on the total return pattern. That said, it seems reasonable, considering IWM is trading at a ~50% valuation discount to mega-caps. If the "three-year forward" valuation in IWM equaled that of MGC, IWM would need to outperform by around 100%. However, if we account for the fact that IWM's constituents naturally have greater negative EPS exposure to the economic cycle, it is reasonable that it should trade at a lower valuation than MGC and the S&P 500; however, a 50% discount is, to me, entirely unreasonable.

Economic Considerations of The Russell 2000

In general, the largest companies in the US stock market are multinational firms such as Apple, Amazon ( AMZN ), Microsoft, Google ( GOOG ), Tesla ( TSLA ), and others. The direct, cyclical exposure of these firms' EPS to the GDP growth rate is vague, but we can generally assume it to be lower than that of firms in the Russell 2000. The largest sectors in IWM are industrials (17%), financials (16%), and healthcare (15%). In MGC, it is technology (36%), consumer discretionary (14.4%), and healthcare (13.1%). MGC's exposure to financials (9.3%) and industrials (10.7%) is lower, while its technology exposure is much higher than IWM's (13%). Both funds have ample exposure to cyclical and less cyclical market sectors.

To me, the most significant three companies (Apple, Microsoft, and Nvidia) in MGC are cyclical despite being technology stocks. Those three firms generate substantial income from consumer hardware sales, the prices of which are generally higher than they were years ago. Further, many people are replacing technology hardware at a lower rate than in the 2010s when there was a massive acceleration in hardware performance. Today, newer smartphone models and processors are only minor improvements compared to the magnitude of changes seen in the 2010s. Therefore, I believe investors may significantly underestimate the impact a recession could have on the EPS of most of the most expensive stocks today.

Of course, overvaluation in the S&P 500 does not necessarily imply undervaluation for the Russell 2000. The small-cap indices are more exposed to historically riskier sectors, such as financials and industrials. Further, specifically for financials, regional banks, and similar medium-to-small financial companies constitute a significant portion of the Russell 2000. In my view, smaller financials are much more cyclically exposed than their larger peers because they have less access to market capital and, most importantly, they're "too big to fail," as seen in the various bank failures this year. Bank of America ( BAC ) and Wells Fargo ( WFC ) have the same core issues as regional banks. Still, they can expect direct or indirect government aid if needed due to their substantial market scope. For related reasons, larger financial stocks benefit from the failures of their smaller peers because they can buy their assets at a considerable discount.

At any rate, there is a robust relationship between changes in the manufacturing PMI and IWM's total one-year performance. See below:

The manufacturing PMI measures surveyed changes in business activity from industrial firms in the US, making it a tremendous forward GDP indicator and highly relevant to estimating EPS changes in most of IWM's constituents. Today, the manufacturing PMI is very low, indicating a negative profit trend for most industrial firms (also impacting all other cyclical firms). The Russell 2000's one-year total returns are technically positive but generally low due to the EPS slowdown. Of course, the S&P 500's total one-year returns is ~16%, so its performance gap is quite large compared to its larger peer.

Based on the "Mishkin-Estrella" recession probability indicator, which uses various interest rate data, the odds of a US recession in 2024 are ~60% today. Notably, that is much higher than in all four previous recessions. Historically, recessions usually occur when the yield curve begins to steepen back above 0%. It remains highly inverted today, indicating no 2023 recession; however, that is statistically most likely to occur once the yield curve inevitably rebounds. See below:

Based on this model, supported by recent consumer , industrial , and banking trend changes, the odds of a significant 2024 economic slowdown appear incredibly high. To be clear, I am not stating a 2024 recession is guaranteed, only that many strong historical data points indicate it is more likely than ever (at least since the 1980s). Opinions on this point differ, but the data is what it is, which is what I base my outlook on.

Of course, historical models can become less useful if the environment differs too dramatically. Since 2020, various US and global government actions, such as lockdowns, stimulus, and geopolitical events, have had enormous positive and negative economic consequences, mainly leading to the current inflation debacle. I am basing my outlook on data patterns during the "great moderation" period of ~1985 to ~2015, which saw low inflation. Thus, because inflation is a major factor today, it can push interest rate trends around sufficiently that these models may not be as powerful as they used to be. However, from a risk standpoint, equity investors would likely be wiser to expect a recession since the downside risk in recessions is usually much larger than the upside reward without one.

The Bottom Line

Overall, I am neutral on IWM because I believe its low valuation appropriately discounts it for the higher probability that its constituents will see negative EPS changes over the coming one to three years. However, there is a night and day difference between IWM and the S&P 500 for the Mega Cap ETF MGC. While IWM appears fairly valued, the large and mega-cap indices appear highly overvalued compared to small caps. Even if IWM's constituents have higher EPS exposure to a recession, which is not necessarily true today, I doubt the valuation gap between them is sensibly based on any sound fundamental basis - particularly considering the minor EPS growth differences between them.

Thus, while I would not buy IWM outright, I believe it is an excellent pair trade against the S&P 500, particularly the Mega Cap ETF MGC. To me, that is a great opportunity today because it largely hedges against changes in the economic environment. I expect IWM to outperform its larger peers with or without a recession, so the pair trade hedges that risk and substantially lower portfolio volatility. Over a five-year horizon, I expect IWM to perform at least 40% better. Even on a six-month basis, I believe IWM should outperform because its price ratio with the S&P 500 is at the low end of its channel, creating a decent technical setup for the pair trade. Further, IWM, SPY, or MGC are highly liquid with no material borrowing cost, making for an easier pair trade to manage.

Of course, this pair trade defies the trend that has persisted since 2012, so it is not a riskless opportunity. In stocks, what goes up can often continue to do so, mainly once investors sufficiently disregard fundamentals. In other words, irrational exuberance can negate any potential "gravity" impacting high-momentum stocks. I believe the momentum behind mega-caps has faded enough that I doubt they'll continue to outperform; however, it is a bit early to state that the mega-cap bubble has ended definitively.

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