The Federal Reserve has disappointed investors this year, but that’s OK: markets have adapted.
The stock market has performed well despite no interest rate cuts so far in 2024 and the possibility of just one cut by the end of the year. That’s quite an accomplishment, considering that in January the Fed was expected to cut rates six or seven times in 2024 and interest rates across the economy would be significantly lower by now.
The stock market may seem to be booming, but upon closer inspection, it’s clear that the S&P 500’s recent gains are built on shaky foundations.
AI fever, driven by the belief that artificial intelligence is ushering in a new technological era, has spread among investors and so far has been enough to keep the overall stock market average rising, but the rest of the market has been rather mediocre. In fact, outside of the largest companies, especially tech companies, the overall market performance has been lackluster.
Concentrated Return
One stock in particular has been driving the market rally: Nvidia, which makes the chips and other related infrastructure that power the AI ​​apps that talk, create images and write the software that makes us so happy. Over the past 12 months, Nvidia’s shares have soared more than 200%, giving it a market capitalization of more than $3 trillion and making it the biggest company in the U.S. market behind Microsoft and Apple.
Compelling AI giants such as Meta (the holding company of Facebook and Instagram) and Alphabet (which owns Google) have also been among the best performers of late, as well as chip and hardware companies such as Supermicro Computer and Micron Technology.
But when you compare the standard S&P 500 index with a version that’s made up of the same stocks but isn’t as heavily weighted toward the top, it becomes clear that stock market gains are narrower.
First, consider that the standard S&P 500 is what’s called a market-cap weighted index, meaning that it’s weighted most heavily in $3 trillion market cap stocks like Microsoft, Apple, and Nvidia, so a 10 percent increase in one of these giants will boost the overall index much more than a 10 percent increase in one of the smaller companies in the index, like News Corp, which has a market cap of about $16 billion.
The standard market-cap weighted S&P 500 is up nearly 14% this year, an impressive gain in less than six months. However, there is also an equal-weighted version of the S&P 500, in which a 10% gain would have the same effect on a giant like Microsoft or a large company like News Corp. The equal-weighted S&P 500 is only up about 4% this year. Similarly, the non-market-cap weighted Dow Jones Industrial Average (which has many unique quirks that we won’t get into here) is only up about 3%.
Size matters
The bottom line is that bigger is better in the stock market these days. A recent study by Bespoke Investment Group, an independent financial market research firm, demonstrates this. Bespoke divided the S&P 500 into 10 groups based solely on market capitalization. They found that the group containing the largest companies was the only one to post positive returns over the 12 months ending June 7. At the same time, the group containing the smallest stocks in the index posted the biggest losses.
This pattern held true when Bespoke looked at just AI companies: Large companies like Nvidia had the highest revenues, while smaller companies generally lagged behind.
This year alone, stock indexes that track larger companies have outperformed indexes that track smaller caps: The S&P 100, which includes the largest stocks in the S&P 500, is up about 17 percent. The Russell 2000, which tracks all small caps, is up about 1.5 percent this year.
Even among technology stocks, the bull market hasn’t worked equally for all companies. Ned Davis Research, another financial market research firm, said in a report Thursday that companies in the S&P 500 index that design, manufacture and build chips have performed well, but the rest of the technology sector has lagged the index this year.
What this means for investors
I pay close attention to these trends, but as an investor, I try not to worry about them. In fact, I see current market concentration as a validation of my long-term strategy of holding portions of the overall stock and bond markets using low-cost, broadly diversified index funds. I’m fine with the entire market being dependent on a few large companies, but that’s because I’m well diversified. So I’m not too worried about which parts of the market are strong and which are weak.
When it comes to my own portfolio, I’m also not all that worried about the problems that inflation and high interest rates are causing for the bond market.
It should be noted that bond rates are set by traders who have made a bid to raise longer-term interest rates in response to the Fed’s tightening monetary policy and persistent inflation this year. As was widely expected, rates were not cut.
Rising interest rates are a problem because basic bond math dictates that when bond yields (or interest rates) rise, bond prices fall. Bond mutual fund returns are a combination of income and price fluctuations. As yields rise, income rises, but bond prices fall. Many investment-grade mutual funds have been teetering this year, as has their main benchmark, the Bloomberg Aggregate Bond Index.
My fund tracks that index, too. I don’t really make money from bond funds, and haven’t for a few years. But they give my portfolio stability and weight. I don’t love where bonds are going, but I can live with it.
On the other hand, if you are an active investor investing in individual asset classes, stocks or sectors, you have a lot to think about right now. You might bet on the continued momentum of the largest stocks, or even just one stock: NVIDIA. Of course, you might think it would be wise to go in the exact opposite direction. You might want to look for stocks that have been ignored in this narrow bull market – stocks with low market caps but that appear to be high value based on metrics such as price-to-earnings ratios.
Historically, small value stocks have outperformed large growth stocks over the long term, but that hasn’t been the case recently. It may be time to change direction. As you’re shifting your investments, you may come to the conclusion that bonds and bond funds are a waste of time when compared to the stock market and its more spectacular returns.
Getting the right decisions on any or all of these issues could make you a lot of money – some will no doubt do – but if you make a mistake now or later, even if you make a very profitable bet, you could easily lose most of your money.
What the Fed does next is also crucial if you’re planning on betting aggressively on the market. Prolonged inflation convinced policymakers last week that they need to keep the federal funds rate at around 5.3%, high enough in the central bank’s estimates to gradually bring inflation down further. There was a bit of good news on that front, with producer prices falling and the consumer price index dropping slightly in May from 3.4% to an annualized 3.3%, but it’s still too high for the Fed.
Futures markets expect interest rates to remain steady at the Fed’s July meeting, which is exactly halfway between the Republican and Democratic party conventions. However, most traders expect the Fed to cut rates in September, which could trigger a broad rally in the stock market as well as the bond market. With a national election in November, a Fed rate cut in September would undoubtedly please President Biden, but would likely displease former President Donald J. Trump, who is known for being vocal in his feelings.
There are many things to consider, and it’s impossible to know in advance what the best course of action will be in the short term.
So I invest in long-term percentages, based on a lot of academic research that suggests that for most people, you’re better off letting the overall market make your money most of the time. Keep your costs low with index funds, always hold stocks and bonds in the right proportions for your needs and risk tolerance, and try not to worry too much about these complex issues — at least not in your investing life.
I don’t know what the Fed will do next. I care, but I’m not going to let it affect me financially. The bond market is weak. The stock market isn’t completely stable, but that’s OK. There will be some pain ahead, but there will be bigger gains for those who just stick to their guns.
