The winds – are they about to change?

The month of June witnessed price action that looked like last year when a small number of stocks drove most of the market returns for the most part of the year. The difference between large capitalization companies and small-to-mid capitalization companies has become even larger (See Figure 1), forcing investors to think if this will reverse and when. Halfway through the year 2024, we note several headlines highlighting market concentration and the ‘Magnificent 7’ stocks still cornering much of the market action, year-to-date. Recall that in 2023, the broader S&P 500 Index except for the magnificent 7 (Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia and Tesla) was in red until the end of October 2023. After the hints of a shift in interest rate policy stance towards a pause in late October 2023, broader market also took off (See Figure 2).

Figure 1: Large Cap vs. Mid Cap vs. Small Cap, (Jan 2023 to present)

Base: Jan 2023 = 100

 Source: Bloomberg

Figure 2: S&P 500 Index vs. S&P 500 Index (ex – Magnificent 7), (Jan 2023 to Dec 2023)

Base: Jan 2023 = 100

 Source: Bloomberg

Our analysis suggests that year-to-date, except for NVIDIA, the remaining 6 companies within the ‘Magnificent 7’ umbrella have traded in line with the broader S&P 500 Index (See Figure 3). This suggests that the participation of stocks in the market rally so far this year has been relatively broad, in our opinion. This does not mean that the market concentration problem has reduced, it only means that it has not become any more dire than it was last year. This concentration poses risks that if there is a change in the factors that provided wind in the sails of a select few, the markets might struggle.

Figure 3: S&P 500 Index vs Magnificent 7 vs. Magnificent 7 (ex-NVIDIA), (Jan 2024 to present)

Base: Jan 2023 = 100

 Source: Bloomberg

A high interest rate regime helped the cash rich companies (typically larger cap) as they have been able to earn more on their cash hoards, while small-and-mid companies with larger debt loads in general, have struggled. In addition, layering on the rush for artificial intelligence, the difference between ‘the haves and have nots’ has become even starker. The companies that are beneficiaries of this theme and have been sitting on higher cash balances have witnessed turbocharged performance, while others lagged.

As the central banks start cutting interest rates in the coming months, it raises the question of whether the current dynamic will change. We think the answer is in how the fundamental outlook of the economy evolves. A softer economy or a recession will hurt the small-to-mid cap companies more than the larger and cash rich companies with stronger balance sheets, negating much of the benefit of lower interest rates. In this scenario, the market concentration might continue to get worse or stay the same. If the economy stays on firm footing as central banks cut interest rates, the small-to-mid cap companies should start to play catch-up, in our view.