Go where most passive investors don’t: The “left over” 77% of the U.S. stock market

When taken as a whole, Russell Investments believes that U.S. equities (represented by Russell 1000® Index) are currently overvalued – and that’s been the case for some time. The price-to-earnings (P/E) ratio of the Russell 1000 Index is 19.7, compared to the P/E of 16.1 for non-U.S. equities (Russell Global ex-U.S. Large Cap Index) as of May 31, 2016. A more forensic look at the broad U.S. equity market reveals, however, that two extreme segments of the market have posted particularly strong returns over the last 12 months, making the rest of the market look expensive:
  • Internet & Software companies (a.k.a., FANG – Facebook, Amazon, Netflix, & Google and similar stocks). Accounting for about 6% of the Russell 1000 Index as of May 31, 2016, companies in these industries returned 37.5% in the past 12 months. These companies were rewarded for their explosive growth potential in a market environment where growth has been hard to come by. But, this growth is expensive. The P/E ratio for this group of stocks is 45.2 as of May 31, 2016.
  • Utilities, Consumer Staples, and REITs, which made up about 17% of the Russell 1000 Index as of May 31, 2016 and returned 12.5% in the past 12 months. These companies in these sectors are often thought of as “defensive,” sought either for their downside protection, income, or both in uncertain or weak equity markets. This quality has led this group of stocks to have a P/E of 24 as of May 31, 2016.
What about the rest of the U.S. stock market – the remaining 77% of listed large cap companies included in the Russell 1000 Index? Those 794 companies returned a mere 0.2% in the 12 months ending May 31, 2016. Taken all together, the Russell 1000 Index returned 4.4% for that period. Russell 1000 Index Source: BNY Mellon. Data as of 5/31/2016. We believe this majority portion of the market includes companies with attractive valuations and return opportunities – companies with growth potential and defensive characteristics that aren’t overvalued. As of May 31, 2016, that group of 794 companies had a P/E ratio of 18.2, compared to the 27.4 P/E ratio of the combined Internet & Software and Utilities, Consumer Staples and REITs companies and the 19.7 P/E ratio of the overall Russell 1000 Index. Of course, not every one of those companies is undervalued – some are cheap for a reason. We believe that skillful active managers can distinguish between those companies that have the potential to add value over passive investments and those that don’t. Valuation Source: BNY Mellon. Data as of 5/31/2016.

The Bottom Line

Although the U.S. large cap market appears expensive based on P/E ratios as of May 31, 2016, a deeper analysis of the Russell 1000 Index reveals that two pockets of the market representing only 23% of the total market cap of the Index are driving much of that valuation. Strip away those extremes and the valuation of the remaining 77% of the Index appears more reasonable, offering potential fertile ground for skilled active managers to identify the winners from the losers.
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.This material is not an offer, solicitation or recommendation to purchase any security. Any stock commentary is for illustrative purposes only and is not a recommendation to purchase or sell any security. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market. Russell Global ex-U.S. Large Cap Index measures the performance of the global equity market based on all investable large cap equity securities except those in the U.S. All securities in the Russell Global Index are classified according to size, region, country, and sector, as a result the Index can be segmented into thousands of distinct benchmarks. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management. Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand. The Russell logo is a trademark and service mark of Russell Investments. Copyright © Russell Investments 2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty. Russell Financial Services, Inc., member FINRA (www.finra.org), part of Russell Investments. RFS: 17673
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