The Russell 2000 has returned 33.95% year to date as of November 22, 2013, outperforming the S&P 500, which has returned 28.99% in the same period. According to Goldman Sachs Group Inc (NYSE:GS)’s David Kostin, the 4.96% outperformance of small caps over large caps has been driven by improvement in the U.S. economy.

Small caps favored by domestic economic growth

Note that over 80% of Russell 2000 sales are generated domestically versus 66% for the S&P 500 (INDEXSP:.INX). This has benefited small caps as investors have been concerned about outlook and economic slowdowns in Europe and Asia. Internationally, however, both data and sentiment have improved and regional equity indexes have responded accordingly. Production activity has recovered in Europe and Asia, with manufacturing indices showing growth signs instead of contractions. Stronger international performance may favor large caps next year.

US Small Caps Source: FactSet and Goldman Sachs Global Investment Research

Small cap stocks have a low sensitivity to U.S. Treasury rates as their borrowing costs, margins, and earnings do not move in tandem with yields. When interest rates rose between May and September of this year, small caps gained most of their excess returns versus large caps. Goldman analysts forecast rates to rise to 3% in the next 12 months, and this could drive further small cap gains.

Valuations starting to get rich

The Leuthold Group, which has tracked stock market economics and fundamentals since 1981, has lately characterized the recent leadership of small caps as a “final gasp”. The firm calculates that based on a variety of measures tied to underlying company profits and balance sheets, small cap names trade at a premium of roughly 40% relative to the S&P 500 (INDEXSP:.INX). Leuthold concedes that while valuation alone is not a great indicator of future performance in the short or medium term, small cap stocks tend to “fall of their own weight”, making them a poor risk/reward tradeoff relative to larger names.

The Value Line median appreciation potential gauge, which has served as a broad guide to equity opportunities since the 1960s, shows the median of the expected percentage gains of all stocks covered, which add up to about 1,700. This large coverage universe also reflects prospects of small cap stocks. The measure fell to a 45-year low meaning that projected upside has not been this poor since 1968 – the peak of a small cap cycle which ended in a downturn in which blue chips did well for a couple of years.

Goldman Sachs Group Inc (NYSE:GS) acknowledges that valuation is a strong headwind for future small cap upside and that most investors are concerned about it. The Russell 2000 P/E multiple has risen 25% YTD, explaining more than 80% of the index return. It now beats 10 year averages both in absolute and relative terms versus the S&P 500 (INDEXSP:.INX). Goldman’s preferred measure, Price to Book (P/B) ratio has increased from one standard deviation below to approximately one standard deviation above long term averages during the last two years.

Russell 2000 multiple expansion