The prevailing trend towards a “winner-take-all” economy is tilting the scales in favor of large-cap stocks over small-caps and midcaps, despite the Russell 2000 index showing a 17% gain in 2023. Surprisingly, small-cap and midcap stocks appear even more undervalued today compared to a year ago.

However, appearances can be misleading for two significant reasons. Firstly, the iShares P/E calculation only considers profitable companies, understating the true P/E ratio. Factoring in unprofitable companies, the Russell 2000’s P/E, as per Birinyi Associates, stands at 27.1—more than double the reported 11.8 by iShares.

Secondly, despite a robust economy in 2023, the average company in the Russell 2000 reported lower earnings than the previous year, with almost 800 companies experiencing losses over the past 12 months.

The shrinking portion of the earnings pie available to smaller companies is the second reason to question their perceived cheapness. Research by Kathleen Kahle and Rene Stulz reveals a growing concentration of income among the top 100 most-profitable U.S. publicly-traded firms, rising from 48.5% in 1975 to 84.2% in 2015.

This shift towards a “winner-take-all” economy aligns with the theory proposed by Thomas Noe and Geoffrey Parker, suggesting that network effects in the internet economy would lead to dominance by larger corporations.

Over the last five years, the Russell 2000 has lagged behind the S&P 500 by 5.9 annualized percentage points, indicating a consistent trend. If the economy continues its trajectory towards the extreme “winner-take-all” phenomenon, it’s likely that the Russell 2000 will persistently lag behind, despite the seemingly attractive low P/E ratios reported for smaller stocks.

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