Hi everyone. I’m Liz Ann Sonders and this is the July Market Snapshot. Thank you as always for tuning in. On this month’s video I want to share some thoughts on market concentration and what may have perhaps been a turning point in the aftermath of the recent better-than-expected report on inflation and the cementing, at least for now, of an expectation of easier Fed policy to come.
[High/Low Chart for The large get larger for Top 10 S&P 500 stocks as % of total S&P 500 market cap is displayed]
Let’s start with massive weight now accounted for by the largest 10 stocks within the S&P 500. As you can see, they recently hit 38%, which is well above anything seen in at least the past 50 years. The relative outperformance of the largest 10 stocks has obviously flattered capitalization-weighted indexes like the S&P 500 and NASDAQ.
[Table for A tale of two markets for major indexes and maximum drawdowns is displayed]
The fuller story, however, is being told under the surface of the cap-weighted indexes. This table covers three major indexes—the S&P 500, NASDAQ and Russell 2000 Index of small cap stocks. To start, you can see that both the S&P 500 and NASDAQ have strong year-to-date returns, with a lesser return for the Russell 2000. From the lows of the pullback this spring, both the S&P 500 and NASDAQ are up more than 20%.
[Index maximum drawdown from YTD high is displayed]
At the index level, maximum drawdowns year-to-date have been limited to the single-digits; even for beleaguered small caps, with the Russell 2000’s drawdown not reaching correction-level territory of -10%.
[Average member maximum drawdown from YTD high is displayed]
But those maximum drawdowns are at the index level. At the average member level, the story is much, much different. In the case of the S&P 500, the average member maximum drawdown is -16%, which is classified as a significant correction. In the case of the Russell 2000 and NASDAQ, the average member maximum drawdowns are -30% and a whopping -40%, respectively. I am regularly peppered with questions about how “the market” can be so resilient with myriad macro uncertainties, including inflation, Fed policy, geopolitics and the U.S. elections. The answer, as you can see, is that “resilience” has been limited to the indexes courtesy of the outperformance of a small handful of mega-cap stocks. Reality though is much more nuanced and found under the surface of the cap-weighted indexes.
[Table for Left in the dust no more? for % of S&P 500 members outperforming S&P 500 Index as of 7/5/2024 is displayed]
Let’s stay with the S&P 500 for a moment. This table looks at the percentage of stocks within that index that have outperformed the index itself over multiple time periods. This first table is as of July 5 of this year, which was when the majority of these readings were at cycle lows. As you can see, a very low share of stocks were outperforming the index overall regardless of time period. This is where concentration risk becomes more acute: when a small handful of mega-cap stocks are driving performance higher, but shrinking share of the rest of the index is outperforming. It brings up the battlefront analogy often used to describe breadth divergences: when it’s only the generals (even if they’re of the four-star variety) at the front line yet the soldiers have fallen behind, that’s not a strong front.
[Table % of S&P 500 members outperforming S&P 500 Index as of 7/16/2024 is displayed]
Now, we may have hit an inflection point in this data courtesy of the release of much better-than-expected June CPI report on inflation, released on July 10. As you can see, there has been an improvement in the share of stocks outperforming the overall S&P 500—especially over the past month. Although we don’t expect this to persist consistently, we do expect to see more frequent bouts of improved performance away from the mega-cap stocks that have been the market’s darlings since the 2022 bear market ended in October of that year.
[High/Low Chart for So extreme, could a turn be imminent? for % of S&P 500 members outperforming S&P 500 Index (trailing 2 months) is displayed]
We can take a longer-term look at index constituents’ relative performance; and shown here is the share of the S&P 500 having outperformed the index itself over the prior two months. It hit a recent low of only 14%, which was even more extreme than what occurred back in the bubble years of the late-1990s into the peak in early 2000. But you can also see this has begun to turn higher.
[High/Low Chart for Waning dominance of Mag7 for S&P 500 and S&P 500 Equal Weighted is displayed]
Let’s dive a little deeper with this analysis and see how this concentration issue has impacted the relationship between the cap-weighted and equal-weighted S&P 500 indexes. On a year-to-date basis, as you can see, the cap-weighted S&P 500 has outperformed the equal-weighted S&P 500 by more than 11 percentage points.
[High/Low Chart for Bloomberg Magnificent 7 is displayed]
This widening spread between cap- and equal-weighted performance is largely courtesy of the outperformance of the so-called Magnificent 7 group of stocks. As a reminder, they are Apple, Microsoft, NVIDIA, Alphabet, Amazon, Meta and Tesla … in that order in terms of market cap. It’s been our perspective this year—including having opined on it in our June mid-year outlook—that correcting some of this concentration excess could come via “convergence” … with bouts of profit-taking in the mega-cap stocks coupled with better performance under the surface and down the capitalization spectrum. Some of that convergence may have begun, with its sustainability in greater focus now that second quarter earnings season has begun.
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Let me sum things up. Whether using the largest 10 stocks or a subset of that, the Magnificent 7, it’s clear that concentration hit historic extremes this year. The dramatic outperformance up the cap spectrum has flattered the performance of the cap-weighted indexes; while under the surface, there has been significant churn/rotations and even turmoil to some degree. In other words, it’s been a tale of two markets this year; but it’s also been a market that has bred opportunities away from the mega-cap stocks. Whether you’re looking at a small cap index like the Russell 2000 or the equal-weighted version of the S&P 500, there has been notably stronger performance in the aftermath of better inflation data.
All else equal, the possibility of easier monetary policy has accrued to the benefit of stocks away from the mega-cap leaders. But let me conclude with this recommendation: we continue to think there are opportunities within the so called “rest of the market,” including smaller cap stocks. But smaller cap stocks should not be viewed monolithically as they’re not created equal. So for the stock pickers out there, we recommend staying up in quality by screening for stocks that have strong balance sheets, positive profitability trends, high interest coverage and healthy cash flows.
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