The Bottom Line:
- Large cap stocks have significantly outperformed small caps since the October 2022 bear market low, forming a K-shaped divergence.
- Elevated interest rates and a high percentage of small cap companies with no earnings have pressured small cap performance.
- Within large caps, a premium has been placed on higher quality stocks with strong balance sheets.
- The growth trio of technology, communication services, and consumer discretionary has started to fray, with consumer discretionary falling back.
- Investors should consider opportunities outside the Treasury market and look for companies with higher profitability and better interest coverage.
Large Cap Stocks Outshine Small Caps Since October 2022 Bear Market Low
Stark Performance Gap Between Large and Small Cap Stocks
Since the bear market low on October 12, 2022, the S&P 500 has enjoyed a strong bull market run. However, the same cannot be said for the broader small cap universe, as represented by the Russell 2000 index. The performance spread between these two indexes over this period has been a staggering 30% in favor of the S&P 500. This disparity is atypical for the early stages of a bull market, and the weakness in small cap stocks can be attributed to the elevated interest rates resulting from the Fed’s aggressive rate hiking campaign. Small cap companies, especially those with no earnings over the past 12 months, have been under significant pressure due to the higher borrowing costs.
Quality Matters: Divergences Within Large Cap Stocks
Even within the large cap space, there are notable divergences in performance based on the quality of the companies. The Goldman Sachs baskets, which separate stocks into “strong balance sheet” and “weak balance sheet” categories, highlight this bifurcation. Since the Fed’s last rate hike in July 2023, the strong balance sheet index has outperformed the weak balance sheet cohort by nearly 15-16%. This suggests that investors are placing a premium on companies with higher profitability scores, less leverage, and better interest coverage.
Sector-Level Disparities: The Growth Trio’s Dominance
At the large cap sector level, the “growth trio” – consisting of technology, communication services, and consumer discretionary – has been leading the charge since the beginning of 2023. However, this dynamic has started to shift, with consumer discretionary falling behind in terms of performance. Technology and communication services, on the other hand, continue to forge ahead. This sector-level disparity further underscores the k-shaped nature of the current market, where certain segments are thriving while others struggle to keep pace.
High Interest Rates and Earnings Challenges Pressure Small Cap Performance
Stark Performance Gap Between Large and Small Cap Stocks
Since the bear market low on October 12, 2022, the S&P 500 has enjoyed a strong bull market run. However, the same cannot be said for the broader small cap universe, as represented by the Russell 2000 index. The performance spread between these two indexes over this period has been a staggering 30% in favor of the S&P 500. This disparity is atypical for the early stages of a bull market, and the weakness in small cap stocks can be attributed to the elevated interest rates resulting from the Fed’s aggressive rate hiking campaign. Small cap companies, especially those with no earnings over the past 12 months, have been under significant pressure due to the higher borrowing costs.
Quality Matters: Divergences Within Large Cap Stocks
Even within the large cap space, there are notable divergences in performance based on the quality of the companies. The Goldman Sachs baskets, which separate stocks into “strong balance sheet” and “weak balance sheet” categories, highlight this bifurcation. Since the Fed’s last rate hike in July 2023, the strong balance sheet index has outperformed the weak balance sheet cohort by nearly 15-16%. This suggests that investors are placing a premium on companies with higher profitability scores, less leverage, and better interest coverage.
The Growth Trio’s Dominance and Sector-Level Disparities
At the large cap sector level, the “growth trio” – consisting of technology, communication services, and consumer discretionary – has been leading the charge since the beginning of 2023. However, this dynamic has started to shift, with consumer discretionary falling behind in terms of performance. Technology and communication services, on the other hand, continue to forge ahead. This sector-level disparity further underscores the k-shaped nature of the current market, where certain segments are thriving while others struggle to keep pace.
Quality and Strong Balance Sheets Dominate Within Large Cap Stocks
Strong Balance Sheets and Profitability Drive Large Cap Outperformance
Within the large cap universe, a notable trend has emerged favoring companies with robust balance sheets and strong profitability. The Goldman Sachs baskets, which categorize stocks based on their financial health, underscore this bifurcation. Since the Fed’s last rate hike in July 2023, the strong balance sheet index has outpaced its weak balance sheet counterpart by an impressive 15-16%. This performance gap highlights investors’ preference for companies with higher profitability scores, lower leverage, and superior interest coverage ratios. As interest rates remain elevated, the market has placed a premium on financially resilient large cap stocks.
Sector Spotlight: Technology and Communication Services Maintain Momentum
Among the large cap sectors, the “growth trio” – comprising technology, communication services, and consumer discretionary – has been at the forefront since the start of 2023. However, recent months have seen a shift in this dynamic, with consumer discretionary losing steam while technology and communication services continue to charge ahead. This sector-level disparity further emphasizes the k-shaped nature of the current market, where certain segments thrive while others grapple with challenges. As investors navigate this landscape, it becomes increasingly important to identify the sectors and industries that are best positioned to weather the ongoing economic uncertainties.
Quality Reigns Supreme in the Face of Economic Headwinds
As the market continues to grapple with the lingering effects of the pandemic, geopolitical tensions, and the Fed’s hawkish stance, quality has emerged as a key differentiator among large cap stocks. Companies with strong balance sheets, consistent earnings growth, and the ability to maintain margins in the face of inflationary pressures have captured investors’ attention. This flight to quality is evident in the divergent performance of the strong and weak balance sheet cohorts, as well as the sector-level disparities. Moving forward, investors may benefit from focusing on large cap stocks that exhibit these quality characteristics, as they are likely to be better equipped to navigate the challenges that lie ahead.
Technology, Communication Services, and Consumer Discretionary: A Shifting Growth Landscape
Technology and Communication Services Lead the Growth Trio
Within the large cap space, the “growth trio” – consisting of technology, communication services, and consumer discretionary – has been the driving force behind the market’s performance since the beginning of 2023. However, a notable shift has occurred in recent months, with consumer discretionary losing momentum while technology and communication services continue to surge ahead. This sector-level disparity highlights the evolving nature of the market, as investors gravitate towards sectors that demonstrate resilience and growth potential in the face of economic uncertainties.
Shifting Dynamics Within Consumer Discretionary
The consumer discretionary sector, once a key component of the growth trio, has experienced a divergence in performance compared to its technology and communication services counterparts. This shift can be attributed to various factors, including changes in consumer spending patterns, supply chain disruptions, and the uneven recovery across different industries within the sector. As a result, investors are becoming more selective in their approach to consumer discretionary stocks, focusing on companies that have adapted to the new economic landscape and demonstrate the ability to thrive in the current environment.
Implications for Investors in the Second Half of 2024
As investors navigate the k-shaped market in the second half of 2024, it is crucial to recognize the shifting growth landscape within the large cap space. The continued outperformance of technology and communication services, coupled with the divergence in consumer discretionary, underscores the importance of sector allocation and stock selection. Investors may benefit from focusing on companies within these leading sectors that exhibit strong fundamentals, innovative business models, and the ability to capitalize on long-term growth trends. By adapting to the evolving market dynamics and identifying the sectors and stocks best positioned for success, investors can potentially enhance their portfolio performance in the coming months.
Seeking Opportunities Beyond Treasuries: Profitability and Interest Coverage in Focus
Investors Seek Yield Opportunities in Non-Treasury Sectors
As Treasury yields remain subdued, investors are increasingly exploring opportunities beyond the traditional government bond market to enhance their fixed income returns. Sectors such as corporate bonds, municipal bonds, and asset-backed securities have garnered significant attention, as they offer the potential for higher yields while still providing a measure of stability and diversification within a portfolio.
Profitability and Interest Coverage Ratios Guide Investment Decisions
In the quest for attractive yield opportunities outside the Treasury market, investors are placing a greater emphasis on the financial health and stability of the issuers they consider. Key metrics such as profitability and interest coverage ratios have become essential tools for assessing the creditworthiness and risk profile of potential investments. Companies with strong profitability and the ability to comfortably meet their interest obligations are more likely to weather economic challenges and maintain their debt payments, making them more appealing to yield-seeking investors.
Balancing Yield and Risk in a Diversified Fixed Income Portfolio
While venturing beyond Treasuries can offer the potential for higher yields, it is crucial for investors to carefully evaluate the risks associated with these alternative fixed income sectors. Factors such as credit quality, duration, and liquidity should be thoroughly considered when constructing a diversified fixed income portfolio. By striking a balance between yield and risk, investors can aim to optimize their returns while managing their exposure to potential market volatility and credit events. Consultation with financial advisors and thorough due diligence can help investors navigate this landscape and make informed decisions aligned with their investment objectives and risk tolerance.
