US stocks are currently experiencing a remarkable run, with both the Nasdaq Composite and S&P 500 trading at all-time highs, and the Dow Jones Industrial Average not far behind. Despite a relatively smooth ascent this year, with only a modest pullback in mid-April when investors came to terms with the Fed’s decision to hold off on rate cuts, the market is becoming increasingly unbalanced. The biggest mega-caps, including Nvidia, Meta, Tesla, Amazon, Alphabet, Microsoft, and Apple, have reached record valuations. Other stocks like Broadcom and Eli Lilly have also seen all-time high market capitalizations. This top-heavy nature of the market has many investors wondering how this new paradigm will resolve and whether the biggest names will continue to grow or if there will be a dramatic reversion to the mean moment.
Passive index fund investors have been rewarded for simply owning the index and riding the wave of large cap stocks. The market-cap weighted benchmark has outperformed the equal-weight version of the S&P 500 by around 10% year-to-date, and the spread between the two continues to widen. Additionally, large caps have significantly outperformed small caps, with the S&P 500 showing around a 15% outperformance over the Russell 2000. This outperformance of large caps over small caps has been especially pronounced in 2024, with small caps flatlining while large caps continue to rise to new heights.
The divergence between large caps and small caps is expected to depend on two main factors in the near future. First, the impact of Artificial Intelligence (AI) will play a crucial role in shaping the market landscape. The Mag 7+ stocks are heavily invested in AI applications, and the next phase of the AI revolution will depend on non-tech corporations integrating AI into their business models and providing tangible evidence of its benefits. Second, Fed policy decisions, particularly interest rate cuts, are likely to be a catalyst for small-cap stocks. While the Fed is expected to cut rates at least once in 2024, the timing and extent of rate cuts will play a significant role in determining the performance of small caps in the market.
Investors are advised to consider rebalancing their portfolios to include exposure to US small and mid-cap stocks in anticipation of potential Fed rate cuts in the next six months. Mid-caps, in particular, have healthier balance sheets compared to small caps, with only 20% of mid-cap companies being unprofitable as opposed to 42% of small caps. While it can be challenging to time a reversion to the mean moment in lopsided markets, the prospect of Fed rate cuts provides an opportunity for investors to adjust their allocations to take advantage of potential shifts in the market.
Overall, the current market environment is characterized by the dominance of large cap stocks, particularly the Mag 7+ names, which have reached unprecedented valuations. The outperformance of these stocks, driven by factors such as AI investments and Fed policy decisions, has led to a significant divergence between large caps and small caps. As investors navigate this unbalanced market, careful consideration of portfolio allocations and a proactive approach to potential market shifts, such as Fed rate cuts, can help investors position themselves for potential opportunities in the evolving financial landscape.
