SPY has outperformed IWM by 50%

SPY has outperformed IWM by 50% over the past 5 years. Same goes with outperforming the indices of Europe, Japan and Emerging Markets.

Is this a good trade? Long SPY short IWM/VGK/EEM/EWJ. Why or why not?

In the short to medium term it probably is. Larger companies generally have better cash positions and better access to financing. Plus the S&P500 is dominated in market cap by companies like Amazon, Apple, Microsoft, etc. These companies have strong cash positions and/or more less vulnerable business models and in some cases may experience growth. However one needs to pay close attention because small caps usually lead recoveries.

Jeff

Da,

This is a question I have been thinking about a lot. The question is similar to the questions and methods of pairs trading. But I have been looking at correlations of ETFs more for my own personal portfolio.

What is best to do will depend on whether you think the assets you are considering will continue to trend or whether you think they will mean-revert.

If you think SPY and IWM are trending now then the trade you suggest would be good.

If you think things will mean-revert then you want to do the opposite don’t you? You want to short SPY and go long IWM.

Personally, I am stepping back and using this site: PORTFOLIO VISUALIZER .

If I think things are trending I would maximize the Sharpe ratio. This will give more weight to what is trending while taking volatility and correlation of the assets into account. You can do this with assets you are shorting.

If I do not know whether things will trend or mean-revert I would use the minimum variance portfolio which would be indifferent to whether the assets mean-reverted or trended. This portfolio will tend to out-perform long-term because of fewer big drawdowns and it will be less risk.

You can also find a lot on the internet about adjusting according the expected volatility. I think I will ultimately do that. Maybe adjust the expected volatility of the portfolio according to the ViX or the recent historical volatility in the market.

I might even use leverage or 2X ETFs when the volatility in the market is low.

FWIW.

Best,

Jim

What Portfolio123 allows you to do is to choose the best stocks from each of SPY and IWM. That’s what I’d recommend. You could, if you wanted, also short the worst stocks in SPY as a hedge.

After much deliberation, I concluded the SPY is not a good index anymore. It has 500 stocks in theory but
AAPL + MSFT + AMZN + GOOG + FB + Berkshire has as much weight as the bottom 400 stocks in there.

You have companies like MSFT with 5.7% weighing and GPS and M with 0.01%

Large-cap stocks almost always outperform small-cap stocks at the end of bull markets. And cap-weighted indexes outperform equal-weighted. Typically characterized as the ‘generals’ leading the charge of the ‘soldiers,’ this pattern has been a rule-of-thumb since the creation of markets. It is one of several characteristics that change as markets mature. Another is that Growth shares outperform Value stocks late in the cycle, and vice-versa at the beginning.

As bull markets become mature, valuations get extended, and the threat of a recession/selloff draws nearer, investors (both retail and institutional) tend to favor the well-established, larger companies that are more consistent and predictable in their earnings and price-performance. Then it becomes a self-fulfilling cycle as the largest-capitalization companies outperform all the rest – and that justifies investing in them even more.

If we are entering a recession/bear market (and practically every indicator we watch shows that we are), this inter-market relationship will break down. At the bottom of a bear market, the roles will reverse and more nimble, smaller-capitalization shares will significantly outperform large-capitalization companies.

Chris

You may be right. But at the same time the stock market is always pricing in the future, not the present.
Generally, recessions are short, at least when it comes to the stock market. Look at a 20 year old chart of the SP500. Practically all “recessions” where just interruptions of a bull market and great buying opportunities. So the label “bear market / recession” may be right, but it could still be the right time to buy stocks.

That’s when market timing comes into play. Sentiment could be of help here.
In January it was extremely bullish, on March 23 (the low of this crash) it was extremely bearish.

Isn’t it funny that we see this usually “after the fact”?
I for one saw it but foolishly did not act on it.
I hope others did better than me or had better indicators.

Very likely to be temporary. Small cap value has historically outperformed large cap over the long term. Also, worth noting that:

“As one example, when we compare the earnings yield of the cheapest small stocks (cheapest decile by price-to-earnings) to the most expensive decile of large cap stocks, we see a spread of more than 21%. Following extreme periods like this historically, small value outperformed large growth by 16.8%/year over the subsequent 10 years.”

https://www.osam.com/Commentary/blizzardwintericeage

Factor diversification is not a bad thing.

Yes and no. It totally depends on your starting and ending dates.

But why? What will actually cause major investors to reverse course and buy cheap small caps instead of expensive large caps? There has to be some sort of catalyst, doesn’t there? This argument depends on one word: “historically.” There needs to be a better reason than that.

“Historically” is not a catalyst. It’s not even a reason. But it’s a proof. It’s a backtest that has worked out of sample for a century.

The reason why small caps will go up faster from here over the long term is that stock prices over the long term track their intrinsic value, and small caps will be trading below intrinsic value; especially compared to large caps. So, if one asset class is trading at a discount to intrinsic value relative to another, it will go up faster over the long term. Conversely, if an asset class is trading at a relative premium to intrinsic value it will go up slower over the long term.

What is the catalyst that pushes stocks to track intrinsic value?

Extreme example: Imagine a company making $1 a year per share for the foreseeable future. Is it a good investment? I don’t know. It depends on the price. So, let’s say it’s selling for $3.

Would I buy it? Absolutely! If I had the capital, I would buy out the company, wait three years, and then resell the company (probably at 10x earnings or more). So, I get my money back in cash flow alone, plus another 333% cumulative return in capital gains. Does it need a catalyst? I wouldn’t mind. Actually, I would mind. I would hate to see it getting bought out at a 50% premium when I could make 333% on my investment over three years.

What will make the price go up? The very fact that it can be bought out. Alternatively, the company can buy back its own stock at a huge discount. Alternatively, the company can pay out cash earnings in dividends, which would give us a sustainable dividend yield of 33%!

Why is cheap now? Because people sold to raise cash, and others didn’t buy because they see prices falling and are holding out for a better price. Sometimes people don’t realize the value.

This is the essence of value investing as practiced by Warren Buffett and others. This knowledge allowed me to sleep well during '08 while being fully invested, and allowed me to recover from the '08 crash by the end of '09.

How do you know small caps are trading below intrinisc value?

THe Russell 2000 including negative earnings has a trailing PE of 51 and that’s not even counting the forward 12 month which will be worse.

Small caps have been trading at higher P/E than large caps for ten years now. Nothing has changed. Ten years ago, large caps were trading at a median forward earnings yield of 5.7% while small caps were trading at 4%, a ratio of 1.41. Five years ago, large caps were trading at 5.1% and small caps at 4%, a ratio of 1.27. Right now large caps are trading at 4.9% while small caps are at 3.6%, a ratio of 1.36. I don’t see a pattern here. All I see is stasis.

I think we need to account for negative earnings in calculating the index P/E. Most numbers do not do that.
If you see this back in 2017, Russell 2000 had a P/E of 76 including negative earnings.
The usual methodology is to just remove all the companies with negative earnings and only count the positive ones.

[quote]
Small caps have been trading at higher P/E than large caps for ten years now. Nothing has changed. Ten years ago, large caps were trading at a median forward earnings yield of 5.7% while small caps were trading at 4%, a ratio of 1.41. Five years ago, large caps were trading at 5.1% and small caps at 4%, a ratio of 1.27. Right now large caps are trading at 4.9% while small caps are at 3.6%, a ratio of 1.36. I don’t see a pattern here. All I see is stasis.
[/quote]Source?

[quote]

I did a screen of all fundamentals. I separated them as follows: large caps = top 25% by market cap, small caps = bottom 75%. I then took the median forward earnings yield at each point in time, calculated as CurFYEPSMean/Price. I excluded all stocks with CurFYEPSMean = NA. The results were pretty consistent no matter what date I performed the screen on in the last ten years. But twenty years ago the situation was reversed: small caps were better earners than large caps.

Let me try to do a custom series and post that if I can.

OK, here’s the aggregate series. It uses one rule:

UnivMedian(“MktCap > 2000”,“CurFYEPSMean/Price”)/UnivMedian(“MktCap < 2000”,“CurFYEPSMean/Price”)

As you can see, large caps have had higher forward earnings yields than small caps for about nineteen years now.

I’ve made the series public so you can play with it: https://www.portfolio123.com/app/series/summary/11269?mt=8


[quote]
I think we need to account for negative earnings in calculating the index P/E. Most numbers do not do that.
If you see this back in 2017, Russell 2000 had a P/E of 76 including negative earnings.
The usual methodology is to just remove all the companies with negative earnings and only count the positive ones.

https://www.marketwatch.com/story/heres-the-shocking-truth-about-the-russell-2000s-pe-ratio-2017-08-18
[/quote]Stocks losing money should legitimately count as 0; but not less than that.

Looking at this it’s looking like small caps are more overvalued than they ever have been
To get back from 2.2 on the trend line to 1.5 does this imply small caps need to be cut by 0.7/2.2 or something like 30% more?

You want to go back to 1, not to 1.5. 1 means that small caps and large caps are equally valued.

Here’s what’s behind all this. Below are two charts. The first represents the median annual income of a large cap from 1999 to today (defining large caps as stocks with $2 billion market cap or greater). The second represents the median annual income of a small cap from 1999 to today (defining small caps as stocks with less than $2 billion market cap but with analyst coverage). Over the past twenty years, large caps have increased their earnings while small caps have decreased theirs to the point that the typical small cap is earning less than zero.

Is there a precedent for this, historically? I have no idea, and I’d love to find out. But it’s a dire state of affairs, and it may be at the root of the subject of this thread.



Yuval,

Is this correct?

Large-caps had a HUGE spike (100% increase) in “median annual income” at the end of 2008. A period that people have been calling a recession? The increase in median annual income is declining rapidly but remains elevated right up to early 2009 which would be near the bottom or the recession, I think.

Much of the economy is completely shut down now with both supply and demand problems. And again we see a spike in “annual incomes” for both large-cap and small-caps in early 2020?

I get that this is probably TRAILING twelve months but I still have trouble accounting for all 3 of the spikes mentioned above.

Thank you in advance for any comments helping me to understand.

Best,

Jim