Top Line
Wall Street just saw David defeat Goliath, a potentially worrying development given that the recent stock market rally has been concentrated in the world’s largest stocks. But research suggests that, at least in the short term, small caps outperforming megacaps could be a healthy development for the overall market.
The stock market rally may extend.
Key Facts
Thursday was the best relative day for small-cap stocks in recent years, by a variety of metrics.
The Russell 2000 index, which tracks 2,000 small U.S. public companies with a median market capitalization of $900 million, rose 3.6%, while the tech-heavy Nasdaq 100 fell 2.2%, the second-largest difference in the two indexes’ daily performance in the past decade, according to FactSet data. Meanwhile, the top 10 stocks in the S&P 500 index underperformed the other 490 stocks by the fourth-largest margin in the past 20 years, according to UBS research.
Of particular note, the “Magnificent Seven” — the seven biggest artificial intelligence (AI) stocks that include Nvidia and Microsoft and have underpinned much of the broad rally over the past two years — saw their worst performance since October 2022, with the seven stocks falling a combined 4.3%, according to Deutsche Bank strategist Jim Reed.
The positive trend for small-cap stocks continued on Friday, with the Russell 2000 Index rising 1.8%, while the Russell 1000 Index, which tracks the 1,000 largest U.S. stocks, rose 0.7%, with the top seven stocks rising an average of 1.1%.
While this shift seems unwelcome given that the market is top-heavy, history suggests further gains could be made.
UBS strategist Patrick Palfrey wrote in a client letter on Friday that in the five most similar sessions in which the S&P’s 490 small-cap stocks outperformed the top 10 on a day like Thursday, the S&P rose an additional 4.5% over the following month, even as the top 10 stocks fell an average of 4.8% over the same period.
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Important Quotes
“The performance gap between tech stocks and the rest of the market is so large that it’s reasonable to expect it to continue to narrow as the market more fully accepts the idea of ​​a rate-cutting cycle beginning,” summarized Tom Essaie, founder of The Sevens Report, noting that non-tech stocks could stage a catch-up rally in the near term. Essaie was referring to Thursday’s strong inflation data, which has strengthened calls for the Fed to cut interest rates soon. That would be a broad boost for most stock markets but would tend to favor certain interest-rate sensitive sectors such as real estate.
Big numbers
33%. That’s the weighting of seven companies in the market-cap-weighted S&P as of Thursday’s close, according to FactSet data. In other words, their combined market capitalization of $16.4 trillion is as large as the combined market capitalization of the index’s 427 smallest constituents.
Points to note
How will the just-beginning second-quarter earnings season affect perceptions in a market crowded with large companies? According to Anne Larson, a quantitative analyst at Bernstein, the seven largest companies are expected to have a combined annualized earnings growth rate of 27.8% for this period, nearly five times the 5.2% earnings growth rate forecast for the other 493 companies.
References
