Large caps have been all the rage on Wall Street for some considerable time already – first and foremost the famous “magnificent seven”. They also had a major influence on the recent strong performance of the S&P 500, the blue chips index putting on a good third over the last two years. In 2023 alone this group were responsible for more than half of the share price gain. That is hardly surprising, given that the tech giants also drive the index's movement. Four of the M7 companies alone are currently expected to report year-on-year growth of 56.4% in the second quarter. According to FactSet, the quartet, comprising NVIDIA, Amazon, Meta Platforms and Alphabet, is why average earnings growth rate for the S&P 500 is expected to reach 9.7% in the second quarter of 2024. Without these four the increase would be only 5.7%.
Nevertheless, there have been increasing suggestions recently that the magnificent seven may be overvalued. A look at the price-earnings ratio brings these fears into sharp relief. On average, the seven tech groups are aiming for an ambitious PER of 33 in 2025. The fears led to a marked correction in mid-July, with NVIDIA, for instance, suffering a drop of around one quarter in its share price in just a few days of trading. The weakness of the techs also had a prevailing influence on the S&P 500, which in July fell just under 5% from its high. The dive heralded the hour of US second-line stocks. The Russell 2000 small-cap index was already taking off at the beginning of the month, recording an impressive performance of 11% in July. Although the S&P 500 was able to recover somewhat towards the end, the “minis” raced ahead to leave a gap of 10 percentage points. That gave the Russell 2000 the lead again after a long time. With the sprint, the index is still a good 7 percentage points in front of the blue-chip barometer on a one-month view, i.e. including the hefty market correction at the beginning of August (see chart).
The S&P 500 may still have its nose in front on a longer perspective, yet not only could the outperformance of the large caps over small caps in the USA diminish in the near future, but the second-line stocks could even retake the lead. That is because smaller companies are in the process of sparking the growth engine. In the current reporting season on the second quarter, analysts expect the Russell 2000 to post average earnings growth of about 18%. This follows five quarters characterised by declining profits. As mentioned above, companies in the S&P 500 are anticipated to achieve just half this figure. Annual profits of small caps in the years 2024 to 2026 are even set to increase twice as fast on average as those of the blue chips.
The expected turnaround in interest rates is also expected to play into the hands of smaller and mid caps. In its last interest rate decision the Fed, as expected, left the interval at 5.25% to 5.50%, but Fed boss Powell made it clear in the press conference that there had been further progress both on inflation and in the labour market. On the subject of the labour market, fears of recession led to jitters on the stock market after far fewer jobs than expected were created in July. This also had an impact on interest rate expectations: before the report came out, the great majority of the market had assumed a first cut of 0.25 percentage points in September, but afterwards almost 80% were arguing for a reduction of half a percentage point. This is to be followed by two additional downward moves by the end of the year. In principle, a looser monetary policy enhances the attractiveness of equity investments, all the more so if, as in the case of small caps, they are stocks offering appealing valuations. Furthermore, small caps are regarded as particularly dynamic instruments that can adjust rapidly to changing market conditions and deliver disproportionate growth. This could, in turn, persuade investors to swing the pendulum more towards small caps in their strategic asset allocation, especially as they also offer promising diversification for the portfolio.
Source: Bloomberg