Mice that roar

Since its creation in 1957, the S&P 500 has been a bellwether of the US economy. From railroad giants and industrial conglomerates to potential beneficiaries of the artificial intelligence revolution, more than half a century of economic history is reflected in its ever-changing composition.

The latest chapter of this story was the emergence of the ‘magnificent seven’: a collection of tech giants that accounted for 60% of the S&P 500’s total market gain last year.¹ Our colleagues in the Active Equity team have analysed this phenomenon and offer a view on whether performance can be maintained in 2024.

But for investors seeking diversified exposure to the US equity market, there are compelling alternatives to the increasingly top-heavy S&P 500.

Balance your core

Among the top 10 constituents of the S&P 500, just two fall outside the tech bracket.² As well as the outsized performance contribution from the tech sector last year, IT represents almost 30% of the index by total weight.

US small cap indices, by contrast, currently provide a more balanced representation of the different sectors within the economy. For example, in the Russell 2000 index, industrials, financials, health care, consumer discretionary and technology each represent between 13% and 18% of the index weight.³

Small-cap indices also tend to provide access to more specialised companies and more geographically localised exposure to the US economy than large-cap indices, which by their nature tend to include more global-facing companies.

The outlook for US small caps

2023’s rally in large-cap equities has widened the valuation gap versus small caps, leaving small caps undervalued on a relative basis.

Approximately a fifth of the US small-cap universe by market cap has exposure to negative earnings, compared with around a 10th for large caps. Hence using unadjusted price to earnings (P/E) ratios is likely to result in spikes and outliers especially around times of high market volatility, when earnings deteriorate. Therefore, for our analysis to make valuations more comparable, we have only considered companies with positive trailing 12-month earnings.

Using this measure, the ‘positive’ price-to-earnings ratios of small caps are also low compared with their history, so reversion to mean would play in investors’ favour.⁴

Expectations for US small-cap net margins are also supportive, with consensus expectations of a 27.5% earnings expansion in the second quarter of this year – significantly ahead of expectations for the S&P 500 and other indices dominated by large caps.

Quality that counts

We believe combining this supportive valuation and outlook picture for US small caps with a quality overlay can help to capture potential upside while adding resiliency.

A quality overlay could overweight those companies within the US small-cap universe that have robust financial characteristics, such as higher profitability and lower leverage.

In the event that the macro environment worsens, we believe this could limit exposure to those companies most at risk.

Roads to diversification

Can the large-cap indices’ recent run continue, and what role might the ‘magnificent seven’ play in 2024? Here, we must be humble and acknowledge that we do not have a crystal ball.

However, as believers in diversification,⁵ we are mindful of the dangers of recency bias, which might lead investors to expect continued outperformance from last year’s winners. In this context we see value in investment approaches that diversify away from a handful of mega caps.

This could include thematic indices, which replace or complement market-cap exposure with equal-weighted investments leveraging emerging areas shaping our future.

Equally, US small caps with a quality tilt can provide a very different set of exposures from market-cap weighted indices. For investors looking to mitigate rising company-specific risks in widely followed equity indices, small caps could provide a very different way of accessing the world’s biggest economy.

1. Source: Bloomberg as at 29 December 2023. See https://www.lgimblog.com/categories/investment-strategy/will-the-magnificent-seven-ride-again/ for full analysis.

2. Source: S&P 500 December 2023 factsheet data

3. Source: FTSE Russell as at 29 December 2023.

4. Source: Comparison of Russell 2000 0.4 Quality Target Exposure Factor Index (R2QTEN) versus S&P 500 based on Bloomberg data as at 29 December 2023. The relative valuation of R2QTEN vs S&P 500 is below May 2020 to December 2023 average level.

5. It should be noted that diversification is no guarantee against a loss in a declining market.