SPY and IWM’s Unprecedented Divergence Explained

The stock market is at a record high, but don’t tell that to investors in the iShares Russell 2000 ETF (IWM). The small cap exchange-traded fund is mired in a bear market while the SPDR S&P 500 ETF Trust (SPY) is hitting all-time highs—an unprecedented divergence in performance between the two ETFs. 

On Wednesday, the S&P 500 rocketed to fresh highs just under 5,000— but the Russell 2000 was slightly lower on the day, a sight that’s become increasingly common this year. 

While the large cap S&P 500 has recovered all its bear market losses and more, the small cap Russell 2000 hasn’t, and remains more than 20% below its all-time high from 2021.  

A drawdown of 20% or more is considered a bear market by many investors, which means that the small cap index is in a bear market even as the large cap index is in a bull market.  

There have been instances when the S&P 500 recovered from a bear market faster than the Russell 2000. But there’s never been an instance when the large cap index is hitting records while the small cap index is down 20% or more from its high.  

That forking has some investors weighing whether small caps are undervalued or whether large caps are overvalued.  

The question echoes a debate that’s been raging among investors in the S&P 500. The traditional market-cap-weighted version of the index has performed much better than its equal-weighted counterpart, which is tracked by ETFs like the Invesco S&P 500 Equal Weight ETF (RSP).  

RSP is still 4% below its all-time high, while the regular S&P 500 is hitting new highs thanks to monster gains in an increasingly narrow group of megacap tech stocks.  

RSP and IWM vs SPY: An Earnings Tale  

Some investors have used the underperformance in RSP and IWM versus S&P 500 funds like SPY as evidence of value in those ETFs.  

But although the market-cap-weighted S&P 500 has become increasingly top-heavy, there’s no guarantee that indexes like the Russell 2000 or the S&P 500 Equal Weight ETF will outperform it. 

As Goldman Sachs Equity Strategist David Kostin recently noted, “improving fundamentals, rather than valuation expansion, have driven the bulk of the [magnificent seven’s] performance since 2019.” 

Kostin is referring to the group of high-flying tech and tech-adjacent stocks including Nvidia, Meta, Microsoft, Apple, Amazon, Alphabet, and Tesla.  

He says that since December 2019, “the magnificent seven stocks collectively delivered a 28% annualized return,” with 27% of that coming from earnings growth and only 1% coming from multiple expansion. 
 
In other words, the S&P 500’s top stocks are surging because of strong earnings, not because investors are willing to pay an increasing amount for those earnings.  

The outsized profit contribution from America’s largest companies isn’t expected to end imminently.  

According to FactSet, just four companies—Nvidia, Amazon, Meta and Alphabet—are anticipated to account for nearly all the S&P 500’s earnings growth in the first quarter of 2024. Their projected 80% spike is largely responsible for the index’s 4.6% growth. Without them, the projected growth rate for the index drops to 0.3%. 

That in a nutshell explains the outperformance of SPY versus RSP this year and over the past few years. 

Meanwhile, the stocks in the Russell 2000 are expected to grow their earnings a whopping 45% in 2024 after a 25% drop in 2023. If that increase materializes, it would likely push earnings for the small cap index to a record high. 

There’s a lot of uncertainty surrounding a gain of that magnitude, but if small caps can deliver the earnings growth that analysts are expecting, then perhaps this year’s wide divergence between IWM and SPY might reverse.