No. of Recommendations: 25
Why do you think this is the case? I see its not as pronounced in the S&P600. Do you think for the S&P 500 its in part, companies are more profitable and maybe with such a large weighting in tech and services rather than say the 90s where the index was more capital intensive with utilities, energy and industrials having a larger weighting?
Why is the US market expensive? The simplest response is "prices fluctuate". There has been almost no penalty for buying dips for a long time, so the market ratchets upwards till something breaks. More subtle answers come from macroeconomics: other things being equal, or even approximately equal, it's pretty much an identity that a rising government deficit will cause corporate profits to soar, which of course causes people to want to own more equities.
Yes, there are certainly some very good large firms that are tech or tech-adjacent. But that isn't the only thing going on. It's still a big market.
I don't think the S&P 600 is cheaper the way that it seems to be. The valuation gap seems large, but the quality-of-firm gap is also large, and perhaps larger than in the past. The quality of small, as opposed to mid-cap, firms in the US had deteriorated a lot, so I will talk about that, as typified by the Russell 2000 crowd. A lot of this info is from a recent FT.com article.
Random observations:
Even the rest of the S&P 500 isn't so hot. The S&P 490 (all but big 10) manages to produce only 2/3 of the total S&P 500 profits.
Smaller companies are much more exposed to higher interest rates than large companies. S&P 500 firms are 6% floating debt. For the Russell 2000 the figure is 30% floating.
BofA estimates that if interest rates stay at their current level, it will translate into a 32 per cent hit to earnings over the next five years. Even if the Federal Reserve starts cutting rates as expected, it will still trim small-cap earnings by 24 per cent.
The share of R2000 firms with negative forward earnings is a bit jagged with the business cycle, but it's basically a steady upward march from 1995 (5% of them) to the early 2020s (30-35% of them). Some of that is due to a big class of profitless biotech firms, but the trend is true even without them. Excluding those, gross profit to assets has fallen from almost 30% in 1995 to consistently under 20% in the last few years.
Why are t he firms worse? The simplest explanation might have a lot of power: private equity. Better quality private firms get bought rather than going public, so the entrants to the public markets are worse on average. And the good public ones get bought, too, leaving the rump. This is compounded by the fact that the giants have eaten the lunch of a lot of firms. There used to be such a thing as a small profitable retailer.
They quote a fellow from Furey Research:
"In the 1990s, small caps routinely delivered returns on invested capital in the teens and even as interest rates declined to 1% in the early 2000s, small company investors could expect low double digit returns from the index. Those days, like my 32-inch waist, are sadly long in the rear-view mirror. Today, the index ROIC is struggling to hang on in the 3-4% range."
Bottom line: I'm not sure going smaller is such a fantastic idea. The results from seemingly similar valuation anomalies in the past may not work out the same way because it's not really the same comparison: there is a lot more "scratch and dent" in the smaller bin these days.
Jim
