With no interest rate cuts so far in 2024 and the possibility of only a modest rate cut by the end of the year, the stock market continues to rally. This is quite a feat, considering in January the expectation was that the Fed would cut rates six or seven times in 2024 and by now interest rates would be very low across the economy.
The stock market may be on the rise, but when you take a closer look it’s clear that the S&P 500’s recent returns rest on a precarious foundation.
AI fever is spreading among investors based on the belief that artificial intelligence is ushering in a new technological era, and that has been enough to push up the overall stock market average so far. But the rest of the market has been pretty dull. In fact, excluding the biggest companies, especially tech companies, the overall market performance is not impressive.
concentrated returns
One stock in particular has driven the market higher: Nvidia, which makes the chips and other related infrastructure behind the talking, image-producing, software-writing AI apps that have captured the popular imagination. Over the past 12 months, Nvidia’s shares have surged more than 200%, pushing its total market value above $3 trillion, putting it in an exclusive territory shared only with Microsoft and Apple in the U.S. market.
Other big AI-based companies such as Meta (the holding company for Facebook and Instagram) and Alphabet (which owns Google), as well as chip and hardware companies such as Super Micro Computer and Micron Technology, have also performed well recently.
But the narrowness of the stock market’s rally becomes apparent when you compare the standard S&P 500 stock index to a version that contains the same stocks but is less top-heavy.
The standard S&P 500 is known as a capitalization-weighted index, meaning that $3 trillion stocks like Microsoft, Apple and Nvidia have the most weighting. So when these giants rise 10%, they tend to move the entire index higher by a lot, whereas a 10% gain by a smaller company in the index like News Corp., which has a market capitalization of about $16 billion, likely won’t.
The standard cap-weighted S&P 500 is up about 14% this year, a spectacular gain in less than six months. But there is also an equal-weighted version of the S&P 500, in which a 10% gain for giants like Microsoft and giants like News Corp. has the same effect. The equal-weighted S&P 500 has gained only 4% this year. Similarly, the Dow Jones Industrial Average, which is not cap-weighted (it has a lot of its own peculiarities that I won’t go into here), is up less than 3%.
Premium on size
In short, bigger is better in the stock market these days. That’s the finding of a recent study by independent financial market research firm Bespoke Investment Group. Bespoke divided the S&P 500 into 10 groups based solely on market capitalization. It found that the group with the largest companies was the only one that posted a positive return in the 12 months through June 7. On the other hand, the group with the smallest stocks in the index suffered the most.
This pattern was also true when Bespoke focused only on AI companies. Big companies like Nvidia benefited the most. Smaller companies generally lagged behind.
During this calendar year, stock indexes tracking the largest companies have outpaced those tracking small-cap stocks: The S&P 100, which includes the largest stocks in the S&P 500, is up more than 17%. The Russell 2000, which tracks the small-cap universe, is up less than 1% this year.
Even among technology stocks, the bull market is not treating all companies equally. While companies that design, manufacture or make equipment for chips (aka semiconductors) are doing well in the S&P 500, all other technology sectors have lagged the index this year, Ned Davis Research, another financial market research firm, said in a report on Thursday.
Implications for investors
While I pay close attention to these developments, I don’t care about them as an investor. In fact, I view the current market concentration as justification for my long-term strategy, which is to use low-cost, broadly diversified index funds to own a portion of the entire stock and bond markets. The overall market’s dependence on a small group of large companies is fine with me, but that’s only because I’m well-diversified. So I don’t worry much about which part of the market is strong and which isn’t.
As far as my own portfolio is concerned, I am not too worried about the problems arising in the bond market due to inflation and higher interest rates.
Note that bond interest rates are set by traders who have reacted to the Fed’s tight monetary policy and stubborn inflation this year by bidding long-term interest rates higher, not lower, as had been widely anticipated.
Higher rates are a problem because when bond yields (or rates) rise, their prices fall, as basic bond math dictates. Bond mutual fund returns are a combination of income and price changes. While higher yields generate more income, they hurt bond prices. Many investment-grade mutual funds are treading water this year, as is their main benchmark, the Bloomberg Aggregate Bond Index.
My own funds track that index. I’m not making any real money with my bond funds, and haven’t for several years. But they generally provide stability and consistency in my portfolio. I’m not happy with what’s happening with bonds, but I can live with it.
On the other hand, if you are an active investor who bets on individual asset classes, stocks or sectors, there is still a lot to think about. You can bet on the continued momentum of the biggest stocks – or even on just one, Nvidia. Of course, you may believe that going the other way completely makes more sense. You can look for stocks that have been overlooked in this narrow bull market – stocks with low market capitalizations and that appear to be overvalued based on metrics such as their price-to-earnings ratio.
Historically, small-cap value stocks have outperformed large-cap growth stocks over the long term, although that hasn’t been the case recently. Perhaps it’s time for a change? While you’re making changes to your investments, you may also conclude that bonds and bond funds are a waste of time compared to the stock market and its fantastic gains.
Make the right decisions on any or all of these issues and you can make a lot of money. Some people will undoubtedly do this. But if you make a mistake sooner or later, you can easily lose most of your money, even after making some very lucrative bets.
If you’re willing to make active bets on the market, what the Fed does next also matters a lot. Persistent inflation convinced policymakers last week that they needed to keep the federal funds rate at around 5.3% — high enough to gradually reduce inflation further, according to the central bank’s estimates. There has been a little good news on this front, with producer prices easing and the consumer price index falling slightly to a 3.3% annual rate in May, down from 3.4% — but still too high for the Fed’s comfort.
The futures market anticipates that the Fed will keep rates where they are at its July meeting, which falls right in the middle of the Republican and Democratic conventions. But most traders are betting that the Fed will cut rates in September. That could trigger a broad rally in the stock market, and for bonds, too. With national elections in November, a Fed rate cut in September would undoubtedly please President Joe Biden and, I suspect, anger former President Donald Trump, who is known for expressing his sentiments vocally.
There’s a lot to think about, so much so that it’s impossible to know in advance what the best short-term steps will be.
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