INSIGHTS

On July 23, 2024

Growing Market Divergence Between Large and Small Cap

The U.S. economy grew to a record $28 trillion annualized in the first quarter 2024, the equity market added $9 trillion over the past year, reaching a record $57 trillion, and our WCA (Washington Crossing Advisors) Barometer shows positive — albeit fading — strength. Despite this, popular indices’ gains are driven by a few mega-capitalization (mega-cap) companies, leading to less diversification. Historically, smaller companies thrive in expansions and high-risk environments, yet today’s market favors mega-caps.

Despite continued strength in the economy and markets, growing concerns about market divergences exist. Popular indices are reaching new highs, driven mainly by a few trillion-dollar mega-cap companies. This concentration means market averages are becoming increasingly expensive, less diversified, and riskier.

Divergence in Market Performance

Traditional thinking suggests that investors would favor mega-cap companies over smaller ones during a recession or when the market has little appetite for risk. This belief is based on two key ideas:

1. Smaller companies tend to produce faster growth than larger ones during good times and suffer more than large ones in bad times.
2. Smaller companies benefit more from investors’ growing risk appetite as they seek higher returns in exchange for higher risk. Large companies are favored over small ones when investors are worried and seek safety.

However, today’s environment is neither one of recession nor risk aversion. We are in a period of economic expansion and risk-taking. Historically, small companies, represented by the S&P 600 Small-Cap Index, have generated about 50% faster earnings growth during most five-year expansionary periods since 2000. Typically, only during recessions did small-cap earnings per share contract faster than those of the mega-cap S&P 100 Index. Presently, signs of insatiable risk appetite are evident, from tight credit spreads to near-record low equity risk premiums.

Size Premium Dynamics

Instead of placing a premium on smaller companies, the opposite trend is observed. The S&P 100 Index of large caps, which includes most of the mega-caps, now trades at a 60% premium to small caps.

This size premium last peaked in 1998-1999, just before a decade of underperformance for large caps. From 1999 through 2009, the S&P 100 Index fell by 35%, delivering a 10-year total return of -21%. In contrast, the S&P 600 Small Cap Index generated an 85% return, giving smaller companies a relative return advantage of over 106% for the decade.

Uncertainty in Mega-Cap Dominance

It is difficult to determine if we are nearing the end of the current era of mega-cap dominance. What is clear is that the current enthusiasm extends beyond excitement over artificial intelligence (AI). A recent Bloomberg report highlighted that many established technology companies are warning investors of potential risks from disruptive AI. Furthermore, there has been a decade-long momentum building for large caps, with interest in AI technologies only furthering this trend. This increasing concentration among a few large companies means that the market averages are less diversified, amplifying risks associated with individual company performance.

Sustainability Concerns

The growing appreciation for “large” is likely unsustainable. As disparities grow and the valuations of the largest companies reach levels that are difficult to justify, even under optimistic scenarios, the valuation “gap” between large and small is likely to shrink, as it has in past cycles.

Conclusion and Positioning

While mega-cap stocks are currently driving market highs, historical precedents and current risk indicators suggest caution. The premium placed on large companies relative to smaller ones may not be sustainable in the long run. To address the growing imbalances in today’s markets, investors should consider diversifying across multiple asset classes, rebalancing positions that may have drifted from target, and adding non-market capitalization weighted funds or strategies. These approaches may help mitigate some of the risks associated with the current concentration in market leadership and enhance overall portfolio resilience.

CRN: 2024-0717-11837 R

The opinions and views of this commentary are that of Washington Crossing Advisors, LLC (WCA) and are not necessarily that of Advisors Asset Management. Assumptions are estimates based on historic performance and an evaluation of the current market environment. These are estimates only and not intended to represent future performance. References to future expected returns and performance do not constitute a promise of performance for any asset class or investment strategy. Risk refers to an expected standard deviation of returns, a measure of uncertainty around our estimate. The forecasts contained herein are for illustrative purposes only and not to be relied on as advice or interpreted as a recommendation to engage in the purchase or sale of any security or financial product. These forecasts are based upon subjective estimates and assumptions about circumstances and events that may not have taken place and may never do so. In addition, WCA used historic index returns in evaluating past return relationships. This information was gathered from third-party sources WCA deems reliable, but no independent verification has been undertaken. Actual returns could be higher or lower than shown herein.

Description of Indices and Terms: All performance calcula­tions of indices are calculated on a total return basis (reflecting reinvestment of dividends and other earnings). Indices are unmanaged, are not available for direct investment, and have no associated management fees.

• The S&P 100 Index, a sub-set of the S&P 500, is a market capitalization-weighted index that measures the performance of large cap companies in the United States. The Index comprises 100 major, blue chip companies across multiple industry groups.
• S&P 500 Index: Capitalization-weighted composite of 500 stocks traded on the NYSE, AMEX, and NASDAQ; not the largest 500 stocks in U.S., but rather a blend of leading compa­nies in leading industries in the U.S. economy; index comprised of 11 broad industrial sectors.
• The S&P 600 Index is a capitalization-weighted index that represents the U.S. small capitalization market, including companies with a market cap in the range of $300 million to $2 billion. This index consists of 600 domestic stocks chosen for market size, liquidity, and industry representation. The S&P index committee uses the 50th and 83rd percentile of market value of all U.S. companies as a general guideline to identify small cap. None of the companies in the S&P Small Cap overlap with those in the S&P 500 nor the S&P Mid Cap 400.

Any forecasts or opinions expressed herein are WCA’s own as of July 23, 2024 and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.