Stock Market Generals Rest While Soldiers Catch Up

Good Generals exhibit executive leadership and bear responsibility for maintaining an efficient and effective army. The Generals of the US stock market have become mega Generals that have charged far ahead of the army of stocks in the marketplace. The Magnificent 7 or highest value companies in the US have an aggregate $11.5 trillion that comprise 30% of the S&P 500 Index and 44% of the Nasdaq universe of stocks. If money managers outperformed these benchmark stock indices in 2023, then they needed to have an undiversified high-beta portfolio dominated by mega cap technology companies. These Trillion-dollar companies are growing 3 times faster than the rest of the soldiers in their index with twice the profit margins. Without these top seven stocks, the vaunted S&P 500 Index would have modest single digit gains this year with small cap stocks having spent a third of this year underwater.

The last time the tech heavy Nasdaq trounced its small capitalization cousins this much was March 2000 at the peak of the tech bubble. In 2000 the index was infiltrated by scores of companies without earnings or realistic valuation multiples. This time we have the best-run companies in the world with 20 to 30% growth rates, solid earnings and record cash flow and backlogs to back them up.

Small cap stocks, as represented by the Russell 2000 Index (IWM), have underperformed the technology sector for the past 15 years and in the long run they should always underperform. However, we can see a rotation (below) in leadership that occurs frequently inside of these more secular trends. Each of the past 4 years has witnessed leadership changes. In 2022 stocks like Meta and Amazon fell 70% and 50% respectively at their lows while small caps only lost 20%. This year Meta has gained 163%, Amazon 70% and Nvidia 227% while the small cap sector is relatively unchanged with a 3% profit. It’s likely there will be some rotation away from growth as we progress through 2024 and the lagging small cap, financial and health care sectors outperform as interest rates fall in a slower growth economy.

Small capitalization stocks had record sales per employee in 2021 and 2022, driven in large part by inflation. Cost cutting in a falling inflation environment should boost profit margins in this sector, as long as the economy is growing. On a valuation basis the small cap Russell 2000 (not 200) touched multi-year lows in its price to sales ratio last month. This has always been a good time for long-term investing. 

Since the late October lows the tech heavy SP 500 Index and Nasdaq Composite have gained 10 to 13%, with the small cap Russell 2000 Index keeping pace, for a change. Over the past 2 weeks as the benchmark indices have labored sideways, small cap, healthcare and banks have outperformed in what is being perceived as a broadening of the Bull market rally. The more the tech sector stalls, the better the results from the broader market will become. The tech stocks, led by the Magnificent 7 and Cyber Security, should continue higher in spurts, but future gains over the next 12 to 18 months are increasingly being priced into their current valuations. In 2023 investors were rewarded by taking risks in an undiversified portfolio of large cap technology companies. In 2024 relative gains should trend back toward a broader out performance by the rest of the stock market as the Generals slow down to allow the troops to catch up.

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