The Bottom Line:
- Large-cap stocks have significantly outperformed small-cap stocks since the October 2022 bear market low, with a 30% performance spread
- Small-cap weakness is attributed to elevated interest rates, with the best performers having higher interest coverage and stronger profitability
- Within large-caps, there is a significant premium placed on higher-quality stocks with strong balance sheets
- The growth trio of tech, communication services, and consumer discretionary has started to outperform in large-caps
- Investors should look beyond Treasuries for opportunities in the fixed income market as inflation trends lower
Large-Cap Stocks Outshine Small-Caps Since October 2022 Bear Market Low
Divergence Between Large-Cap and Small-Cap Performance
Since the bear market low on October 12, 2022, the S&P 500 has experienced a strong bull market run. However, the small-cap Russell 2000 index has struggled, with a performance spread of about 30% in favor of the S&P 500. This divergence is atypical for the early years of a bull market, and the Russell 2000 was even down in the first year, which is unprecedented. The weakness in smaller-cap companies is attributed to elevated interest rates resulting from the Fed’s aggressive rate-hiking campaign. Within the small-cap universe, stocks with higher interest coverage and stronger profitability have outperformed, but with 40% of the Russell 2000 having no earnings over the past 12 months, the higher rates have put significant pressure on their performance.
Quality Premium Within Large-Cap Stocks
Even within the large-cap segment, there have been notable divergences. Higher-quality stocks, characterized by higher profitability scores, less leverage, and better interest coverage, have significantly outperformed their weaker counterparts. 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% to 16%. This dispels the notion that significant performance divergence only occurs between small-cap and large-cap stocks.
Sector-Level Bifurcation
At the large-cap sector level, the “growth trio” consisting of technology, communication services, and consumer discretionary has started to outperform significantly since the beginning of 2023, before the mini banking crisis. This shift in investor preference towards larger-cap growth areas has contributed to the overall divergence within the large-cap segment. The sector-level bifurcation further highlights the K-shaped trends observed in the stock market, with certain sectors experiencing strong performance while others lag behind.
Elevated Interest Rates Contribute to Small-Cap Weakness
Elevated Interest Rates Contribute to Small-Cap Weakness
Since the bear market low on October 12, 2022, the S&P 500 has experienced a strong bull market run. However, the small-cap Russell 2000 index has struggled, with a performance spread of about 30% in favor of the S&P 500. This divergence is atypical for the early years of a bull market, and the Russell 2000 was even down in the first year, which is unprecedented. The weakness in smaller-cap companies is attributed to elevated interest rates resulting from the Fed’s aggressive rate-hiking campaign. Within the small-cap universe, stocks with higher interest coverage and stronger profitability have outperformed, but with 40% of the Russell 2000 having no earnings over the past 12 months, the higher rates have put significant pressure on their performance.
Quality Stocks Shine Within Large-Caps
Even within the large-cap segment, there have been notable divergences. Higher-quality stocks, characterized by higher profitability scores, less leverage, and better interest coverage, have significantly outperformed their weaker counterparts. 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% to 16%. This dispels the notion that significant performance divergence only occurs between small-cap and large-cap stocks.
Growth Trio Leads Sector Performance
At the large-cap sector level, the “growth trio” consisting of technology, communication services, and consumer discretionary has started to outperform significantly since the beginning of 2023, before the mini banking crisis. This shift in investor preference towards larger-cap growth areas has contributed to the overall divergence within the large-cap segment. The sector-level bifurcation further highlights the K-shaped trends observed in the stock market, with certain sectors experiencing strong performance while others lag behind.
Quality and Strong Balance Sheets Dominate Large-Cap Performance
Large-Cap Quality Stocks Dominate Performance
Within the large-cap segment, higher-quality stocks have significantly outperformed their weaker counterparts. Stocks characterized by higher profitability scores, less leverage, and better interest coverage have shined in the current market environment. 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% to 16%. This disparity in performance highlights the premium placed on quality stocks, even within the large-cap universe.
Growth Sectors Lead the Way
At the sector level, the “growth trio” consisting of technology, communication services, and consumer discretionary has started to outperform significantly since the beginning of 2023, prior to the mini banking crisis. This shift in investor preference towards larger-cap growth areas has contributed to the overall divergence within the large-cap segment. The sector-level bifurcation further emphasizes the K-shaped trends observed in the stock market, with certain sectors experiencing strong performance while others lag behind.
Small-Caps Struggle Amid Elevated Interest Rates
In contrast to the strong performance of large-cap stocks, small-cap stocks have struggled since the bear market low on October 12, 2022. The Russell 2000 index has significantly underperformed the S&P 500, with a performance spread of about 30% in favor of the larger-cap index. This divergence is atypical for the early years of a bull market and can be attributed to the elevated interest rates resulting from the Fed’s aggressive rate-hiking campaign. With 40% of the Russell 2000 companies having no earnings over the past 12 months, the higher rates have put significant pressure on their performance.
Growth Trio Begins to Outperform in Large-Cap Sector
Growth Trio Begins to Outperform in Large-Cap Sector
Within the large-cap sector, a notable trend has emerged since the beginning of 2023, even before the mini banking crisis. The “growth trio,” consisting of technology, communication services, and consumer discretionary sectors, has started to outperform significantly. This shift in investor preference towards larger-cap growth areas has contributed to the overall divergence within the large-cap segment, highlighting the K-shaped trends observed in the stock market.
Quality and Strong Balance Sheets Shine
Higher-quality stocks, characterized by higher profitability scores, less leverage, and better interest coverage, have significantly outperformed their weaker counterparts within the large-cap universe. Since the Fed’s last rate hike in July 2023, the strong balance sheet index has outpaced the weak balance sheet cohort by nearly 15% to 16%. This disparity in performance emphasizes the premium placed on quality stocks, even among large-cap companies.
Small-Caps Struggle Amid Elevated Rates
In contrast to the strong performance of large-cap stocks, small-cap stocks have faced challenges since the bear market low on October 12, 2022. The Russell 2000 index has significantly underperformed the S&P 500, with a performance spread of about 30% in favor of the larger-cap index. This divergence, atypical for the early years of a bull market, can be attributed to the elevated interest rates resulting from the Fed’s aggressive rate-hiking campaign. With 40% of the Russell 2000 companies having no earnings over the past 12 months, the higher rates have put significant pressure on their performance.
Opportunities Beyond Treasuries in Fixed Income as Inflation Eases
Opportunities in Credit Markets as Inflation Moderates
As the trend in inflation continues to move lower, the outlook for fixed income remains optimistic for the second half of the year. However, investors should look beyond Treasuries to capture attractive yields for a longer time period. The credit markets offer compelling opportunities as inflation eases and the economic environment stabilizes.
Diversifying Fixed Income Portfolios
While Treasuries have been a popular choice for investors seeking safety and stability, diversifying fixed income portfolios can provide enhanced returns and better risk management. By exploring various sectors of the bond market, such as investment-grade corporate bonds, high-yield bonds, and emerging market debt, investors can potentially benefit from higher yields and improved risk-adjusted returns.
Navigating Volatility with a Long-Term Perspective
Despite the optimistic outlook for fixed income, the second half of the year is expected to be volatile due to various factors, including the evolution of inflation, the Federal Reserve’s actions, international developments, and the upcoming elections. Investors should maintain a long-term perspective and focus on the overall trend of moderating inflation, which bodes well for the fixed income market. By staying disciplined and diversified, investors can navigate the volatility and capitalize on the opportunities that arise as inflation eases.
