Key Points

  • Fundamentals continue to support an overweight to large caps (S&P 500) at the expense of small caps (Russell 2000).

  • Profitability, profit margins, debt ratios, flexibility/nimbleness, efficiency and market dominance all work to the greater benefit of larger companies.

  • Although the Russell 2000 remains the industry standard (and Schwab’s) small cap benchmark, small cap investors may want to focus on the higher-quality S&P 600 Index.

As most readers know, part of my role at Schwab is being part of the Asset Allocation Working Group, which makes tactical asset allocation recommendations for our clients who would like to apply a tactical overlay to their strategic asset allocation approach. Schwab has myriad strategic asset allocation models to fit our investors’ range of risk/time horizon profiles; and we are firm believers that investors should take a disciplined and strategic approach to investing; even if they desire to apply some shorter-term tactical approaches.

Since March of 2017, we have had an overweight to large cap stocks and an underweight to small cap stocks. Later that year, we moved from an overall overweight to U.S. stocks to “neutral,” while maintaining the bias toward large cap stocks. What “neutral” means in our language is that we have been recommending investors keep their strategic allocation to U.S. equities at their targets. But the bias toward large cap stocks has also meant that we have been recommending an overweight to the S&P 500 and an underweight to the Russell 2000 from a benchmark perspective.

It’s been a while since I wrote about our tactical recommendations; and given small caps’ multiple attempts at upside breakouts over the past couple of years—including late last year—I thought an update was in order.

First, let’s look at a chart of relative performance of the two asset classes. As you can see below, since the inception of our tactical shift to a large cap bias, for the most part, large caps have been outperforming small caps (when the line is moving up). There have been a few attempts at small cap dominance—including March to June in 2018 following the S&P 500 correction from January to February that year—but those attempts have been thwarted.

Large Caps Continue to Dominate Small Caps

Source: Charles Schwab, Bloobmerg, as of 1/13/2020. Past performance is no guarantee of future results.

In terms of fundamentals, here is the punch line: about the only factor some small caps have going for them is a valuation discount to large cap companies. In the aggregate though, in terms of forward price-to-earnings (P/E), the Russell 2000 is trading at a multiple of more than 25, while the S&P 500 has a multiple of 18.3. The S&P 600 index of small cap companies (discussed later in this report) is trading at a slight discount to the S&P 500.

My research associate, Kevin Gordon, recently worked closely with The Leuthold Group on a small cap research project; and some of what’s below comes from those conversations (Leuthold has extremely robust historical data on capitalization ranges). In sum, large cap stocks are currently fundamentally higher quality than small caps, reflected in metrics such as profitability, leverage, economic moats and stability. Although small caps are seen as bigger beneficiaries of business cycle strength—and their sales gains during the best economic times are superior to large caps’—this economic cycle has been unique in its tepid pace of growth.