S&P 500 gains have been led by the most concentrated number of equities, namely mega cap technology stocks, in decades[1].
Market dislocations are creating generational opportunities outside of mega cap technology stocks, including small cap stocks.
The real economy remains resilient while easy financial conditions are keeping valuations of the most liquid stocks propped up; many investors may be unaware of key risks such as concentration and elevated valuations in passive strategies that are often utilized by employer 401(k) plans.
Free Shot on Goal
Imagine you are an NHL player in Game Seven of the Stanley Cup finals. It’s the most exhilarating and high stakes game of your life. The game is tied 3-3 with two minutes remaining in the third period, and emotions are running high. Then the other players, both junior and seasoned, are all suddenly on one end of the ice crowding around one goal. Jabs are being given, punches thrown, and there is total chaos in the pile-up.
Hypnotized by all the commotion, the veteran goalie across the ice decides to skate down the rink to get a piece of the action while leaving his goal unprotected. Then, in the blink of an eye the puck lands between your skates at center ice. While we all know the next part is not how the game actually goes, pretend you have an option as to which goal to take a shot at. Both options would deliver equal reward. Which do you choose?
The obvious answer - take the free shot on the unguarded goal! The risk of doing that is incredibly less than the other option, but again, the potential reward is the exact same. The reality is that humans tend to be anything but rational, especially during times of euphoria, or when emotions are running high. Much like the irrational and “under the influence” decision the veteran goalie made to leave his goal unprotected, human temptation is most commonly to shoot towards where the action is at. This concept applies to the investing world in the same manner. Yet, history has proven that the most successful long-term investors are those with the ability to harness their capacity to remove emotion from the equation and act rationally no matter the environment and circumstances.
The Cocktail Party Stock Market Indicator – A Case for Small Cap Stocks
While most of us are far from being professional hockey players, the same level of irrationality in the hockey analogy exists in the stock market. Stock market participants of all walks of life have been skating to one side of the ice to a degree and magnitude that has not been seen in decades, as noted by how highly concentrated and narrow the stock market has become.
It is probable that you have been at a group gathering or cocktail party recently where the company, Nvidia,[TV4] [VD5] has come up in conversation…I know I certainly have. If you are not familiar with Nvidia, it is a behemoth maker of semiconductors that are in most demand today for artificial intelligence (AI) applications. Here enlies the theory by legendary investor, Peter Lynch, dubbed The Cocktail Party Stock Market Indicator.
When stocks are down and nobody wants to talk about them, especially in a social setting, it is fairly likely that it could be a great time to buy them. Conversely, after a stock has rallied to meteoric levels and you are approached by acquaintances or especially strangers about that stock, it is most likely the opportune to sell. Despite enthusiasm around a very narrow group of stocks today, there is hardly any investor attention to small caps. We consider opportunities in small caps to be where the free shots on goal lie today.
Small cap stocks represent a broad number of companies in the stock market yet make up a significantly smaller part of the market than mega caps based on their market capitalization. The[TV8] typical small cap stock has a market capitalization between roughly $250 million and $2 billion. While most small cap stocks are virtually unknown to the investing public, they represent a critical backbone of the U.S. economy.
There is no denying that small cap stocks have been a frustrating relative underperformer during historic and current episodes of market concentration and exuberance, such as the Technology Bubble of 2000 and today’s large cap stock craze.
However, small cap stocks drastically outperformed following the Technology Bubble which peaked in early 2000. In fact, investors were better off owning small cap stocks leading up to and after the entire Technology Bubble episode despite initial underperformance!
This said, the future investment prospects for high-quality small cap stocks appear quite favorable at today’s depressed valuations. When comparing the relative valuations between large cap and small cap stocks, small cap stocks have not been this cheap since the technology bubble in 2000[2].
*Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data is from 3/1990 to 5/2024.
Small cap stock earnings growth appears to have troughed, and the go-forward expectations for small cap stocks’ earnings growth are currently more robust than large cap stocks. This dynamic is supportive of a higher valuation reset for small cap stocks.
Earnings Growth Trajectory for S&P 600 vs. S&P 500 (Consensus Estimates)
We are firmly aware that many investors tend to think about small cap as riskier types of stocks with relatively less access to economic inputs, such as credit and human talent. We also get pushback that small cap stocks are overweight in cyclical industries such as industrials, financials, materials, or energy. However, we believe that investors are being more than adequately compensated for these risks and should get rewarded with long-term outperformance.
The current market dislocations are creating opportunities in small cap stocks that tend to arise only on a generational basis. As such, we will continue to take these free shots on goal.
Small Cap Stocks Have Outperformed Other Size Segments Historically
The Election and The Economy
With the election coming in November, many investors will seek to reposition their portfolios based on who they think is most likely to step into The White House or even their own political leanings. While presidents and their political party affiliations are not that impactful on stock market performance, presidents do nominate other figures, like the Chair of the Federal Reserve, who set monetary policy and have some control over business and market regulation. Despite this, the stock market has historically tended to rise over the long-term regardless of who is in The White House or their party affiliation.
S&P 500 Cumulative Performance & Presidents’ Parties
While we remain vigilant as it relates to potential policy and regulatory changes that may warrant tactical repositioning of your investment portfolios, it is most prudent to focus on the more paramount drivers of stock performance, such as corporate profits and inflation while keeping a keen eye for risks.
In the real economy, economic growth has continued with hard data pointing at little to no signs of recession. One key data point to consider are new orders for core-durable goods excluding aircraft and defense[3]. Despite the swan songs surrounding a looming recession, manufacturers are spending record amounts for equipment that will lead to future economic and productivity gains. Recent periods of economic weakness include the 2015-2017 secular stagnation and the 2020 COVID-19 pandemic, yet today is not that case.
Manufacturers' New Orders: Nondefense Capital Goods Excluding Aircraft, Millions $
While the real economy is chugging along, liquidity is also abundant in the financial economy despite the Federal Reserve tightening monetary policy. As noted by the Bloomberg United States Financial Conditions Index, the financial economy hasn’t been this loose since the days of zero interest rates and the meme stock craze of 2021.
If the Federal Reserve is serious about tackling inflation, then financial conditions are nowhere near tight enough to return to their 2.0% inflation target. We believe that interest rates will remain at or near current levels for a more extended period of time. With that in mind and considering the shape of the yield curve, our fixed income preference remains tilted towards shorter-term investments with maturities of one to three years. Stock market participants will eventually turn their focus back to fundamental drivers, such as earnings growth driven by the real economy, as opposed to liquidity conditions.
Strategic Positioning
RISE’s core portfolios are constructed to help you achieve your long-term investment goals and objectives via a healthy blend of exposure to undervalued market sectors and companies with a keen eye towards risk.
Average Sector Weightings - All RISE Client Portfolios
Amid today’s highly concentrated and valued stock market, it is prudent diversification, patience, and staying rational that will benefit investors in the long run. The lion’s share of my personal capital is invested alongside yours in RISE’s core portfolios, and the investment decisions that RISE makes are always through a lens that if we would not put our own money in something, we would not put yours in it either.
While many may believe or suspect that their employer 401(k) accounts are well diversified in target date funds, surprisingly, the impact of recent market performance has led to many target date funds becoming susceptible to lack of diversification. As such, we would like to offer you and/or your spouse a complimentary 401(k) review to ensure a prudent level of diversification. Please do not hesitate to let me know if you would like to take us up on this.
Footnotes and Disclosures
The 10 largest U.S. companies accounted for 14% market capitalization of the S&P 500 stock index a decade ago. Today, they account for more than a third.
Historically, small cap stocks have traded at a premium valuation to large caps, while today they trade at a sharp discount.
This metric is used as a proxy for heavy industry capital expenditures and a key indicator of future economic activity.
*RISE Investment Management, LLC (aka "RISE Investments") is a state Registered Investment Adviser. Registration as an investment advisor does not constitute an endorsement by the Commission and does not imply a certain level of skill or training. Advisory services are only offered to clients or prospective clients where RISE Investments and its representatives are properly licensed or exempt from licensure. This publication is solely for informational purposes and past performance is not indicative of future results. Any historical returns, expected returns, or projections are provided for informational purposes only. No advice may be rendered by RISE Investments unless a client service agreement is in place.