Big tech companies are decoupling the stock market from reality

The average stock in the S&P 500 has been hurt more by rising yields and benefited more from falling yields than at any time this century, but the S&P itself is largely immune to the interest rate outlook because the big technology stocks that make up most of the standard market-capitalization-weighted indexes have huge cash reserves that make them immune to the Fed’s influence.

As I argued last week, big names Nvidia, Microsoft, Apple and Alphabet have rallied this year on the back of hopes for artificial intelligence. But the highly unusual divergence in valuations and interest-rate sensitivity between the S&P and its average constituents shows how these big names are distorting the metrics used by “macro” investors who focus on the economy and the Federal Reserve.

The distribution of valuations is clear: if you split the market into deciles by size, the groups rise in valuation pretty steadily as company values ​​rise. Valuations aren’t as steep either: the median S&P trades at 18 times forward earnings, while the big tech-heavy index is trading at more than 21 times. (To be clear, that’s still not cheap by historical standards.)

Sensitivity to interest rates can be measured by comparing the regular S&P 500, which emphasizes large companies, with an equal-weighted version that treats small companies the same as large ones and measures the average stock. The regular S&P was up more than 10% this year through Friday, while the equal-weighted version was up less than 5%.

Its relationship with bond yields has also split, with the average stock now more closely correlated with bond yields over a 100-day period than at any time since 1999, rising when bond yields fall and vice versa. The gap between this correlation and the regular S&P, which has a much weaker correlation with Treasury yields, is unprecedented in data going back to 1990.

Outside of AI, I think this can best be explained by concerns about corporate profits and interest rates, and to a lesser extent the economy.

The big tech stocks that dominate the market are sitting on huge amounts of cash, but the largest companies have opted to refinance their bonds before the Fed starts raising rates in 2022, locking in lower interest rates for longer periods. Smaller companies tend not to have the cash to earn much interest on their savings, increasing their need to issue debt to raise cash. The smallest companies don’t even have access to the bond market, which is one reason the Russell 2000 index of small companies has badly lagged the S&P this year, gaining just 1.6%.

That has investors wary of higher interest rates for a long period of time shying away from the lower end of the S&P 500 Index, even as the major stocks perform well. On days when bond yields fall (as they did on Thursday), small-cap stocks that are sensitive to interest rates typically do well.

But the S&P itself is dragged down by the heavy weight of its dominant big tech stocks, so the index had a bad day on Thursday, even though only 139 stocks fell. The opposite happened on Friday, when bond yields plummeted and the S&P’s smaller and mid-cap components rose more than 1.5%, but the index’s overall gains were only half that amount as its larger constituents held them back.

The large-cap vs. small-cap phenomenon reflects the same disconnect seen across the economy. If the Fed delays cutting rates, as several policymakers have suggested in recent weeks, it will put more pressure on sectors of the economy already struggling with high interest rates. Poor and young borrowers are already feeling the pressure, which is a drag on growth. According to Citigroup’s Economic Surprise Index, economic data has been below expectations for about a month. Sales of big technology companies, unlike mainstream retailers, financial institutions and commodity producers, should not be affected by an economic slowdown unless it is very severe.

What’s odd about the market’s reaction this year is that it’s nearly the opposite of what happened in 2022. Back then, stocks plummeted as investors downgraded valuations on big tech stocks, with the S&P down 19% for the year, while the average stock price only fell 13%. That’s because smaller, lower-valued companies were viewed as less dependent on future profits, which are less valuable in a world of rising interest rates.

Why the difference? AI hopes are offsetting the hit to valuations. This year’s interest rate shock (from six expected Fed cuts to one or two) is on a different scale than in 2022, when rates soared from zero to 4.5%. And investors are waking up to the long-term debt and cash piles that blanket many large-cap stocks.

Investors outside of the big tech sector are right to worry about rising interest rates. For bargain hunters, the S&P’s lofty valuation hides the fact that the 50 smallest stocks that make up the S&P 50 are trading at 15 times forward earnings, nearly as cheap as the entire index was at the depths of the 2020 coronavirus panic.

If interest rates are cut, small businesses will finally have a chance to outpace big tech companies.

Write to James Mackintosh at james.mackintosh@wsj.com.