Credit: Shutterstock photoInvestors constantly wrestle with charts and models to discover hidden gems in the market primed for a breakout. Since the start of the year, approximately a third of the gains made in the S&P 500 (SPX) originated from big tech stocks, namely Facebook (FB), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT) and Google (GOOGL) – now branded with the acronym FAAMG.
The disproportionate returns generated from those five stocks underscore investor over-reliance on mega cap stocks. While the current market landscape favors large corporations, small cap stocks struggle to sustain the post-election rally.
The iShares S&P Small Cap ETF (IJR) is up a mere 2% in 2017 whereas S&P midcap (IJH) stocks have jumped a modest 5% and large caps (JKD) continue to outperform, boasting a 10% increase for the year. In the past, though, large cap stocks have underperformed small companies by a considerable margin owing to disparate fundamental approaches between the asset classes.
Large cap stocks once comprised blue chip companies in the oil and energy sector that promised very little upside and stable dividend yields, while its smaller counterparts tended to focus on growth and thereby experienced large upswings. But the market’s recent infatuation with disruption has led to a strong surge across the technology sector – 5 of the 6 largest publicly traded companies based on market capitalization are now rooted in technology.
Beyond playing catch-up, the reversal in leadership roles arises from a prolonged period of slow economic growth, weak earnings compared to large cap stocks, and the Federal Reserve’s ongoing commitment to raise interest rates.
Earnings for small caps as a whole fell by about 1 percent in the fourth quarter of 2016 beside a 6 percent growth for large corporations. Small companies struggled to keep pace with the broader market as an increasing amount of investment flows into foreign and emerging markets.
In other words, the dramatic surge in earnings growth ignores small businesses who offer a less diverse geographic footprint. This situation will predictably worsen if the dollar continues to trend further downward. In 2017, the dollar index declined 6.5%, despite the common belief that rate hikes appreciate currency value. Additional deterioration of the greenback, in theory, offers greater benefits to large exporters while presenting a significant headwind to small companies.
Overall growth plays an equally important role in the parity between various market segments. Small companies respond adversely to an economic slowdown – U.S. GDP increased at an annual rate of 1.4 percent for the first quarter – on account of a heavy reliance on domestic consumption. The Russell 2000 (RUT), which tracks the performance of small cap stocks, generates about 20 percent of revenues outside the U.S. whereas S&P 500 companies yield 30 percent of its revenue abroad.
However, after underperforming for large chunks of the year, the Russell 2000 and its constituents, look poised to break out in the second half of 2017. If the Trump administration can pass or get the conversation moving forward on any of the nationalistic policies discussed during campaign, small caps can regain some momentum. Isolationist trade policies along with ongoing geopolitical uncertainty favor domestic companies.
Meanwhile, the prospect of tax reform prepares to lift growth and profitability for businesses of all sizes. Additional delays in the President’s agenda will however shelve a potential reversion in sector weighting.
Lagging small cap stocks oftentimes portend an upcoming market breakdown, but the secret to this year’s underperformance isn’t an indictment of over-exuberance, but rather investors' appetite for disruption.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
