The US stock market is riding high, with the Nasdaq Composite and S&P 500 hitting all-time highs and the Dow Jones Industrial Average flirting with record levels. It’s been a smooth ascent this year, with only a brief pause in April when investors realized the Fed would delay rate cuts. But strong earnings quickly reignited the rally, overshadowing any concerns about monetary policy.
At the heart of this market surge are the mega-cap stocks, often referred to as the “Magnificent Seven”—Nvidia (NVDA), Meta (META), Tesla (TSLA), Amazon (AMZN), Alphabet (GOOGL), Microsoft (MSFT), and Apple (AAPL), along with others like Broadcom (AVGO) and Eli Lilly (LLY), have reached unprecedented valuations, leading to a market that’s increasingly top-heavy. This concentration raises questions about the sustainability of this trend. Will these titans continue to dominate, or are we due for a market correction that redistributes value more evenly?
To understand the current market dynamics, it’s crucial to consider the weight of these top stocks in the S&P 500. They now represent over 35% of the index, a level that suggests we’re in uncharted territory. For passive index fund investors, this has been a boon, as simply holding the index has yielded impressive returns. However, those who opted for an equal-weighted approach have lagged behind, underperforming by about 10% year-to-date.
The divergence between large and small caps is even more pronounced. Small caps have struggled amid the Fed’s rate hike cycle, with significant outflows as investors flock to the relative safety of large caps. This has resulted in a 15% outperformance by the S&P 500 over the Russell 2000 this year. The gap has widened over the past three years, with small caps flatlining while large caps soar.
Two key factors will likely determine how this divergence resolves: Artificial Intelligence (AI) and Fed policy decisions. The AI boom has drawn comparisons to the dot-com bubble, but there’s a critical difference. Unlike the speculative tech stocks of the late 1990s, today’s AI beneficiaries are established, profitable companies. Nvidia and Microsoft, for example, have already demonstrated AI’s potential to boost their bottom lines. The next phase will involve non-tech companies integrating AI into their operations, proving its value through improved efficiency and profitability.
This second wave of AI adoption may take time to materialize. Goldman Sachs estimates it could be three or more years before AI’s impact is reflected in economic data. Meanwhile, the Fed’s interest rate decisions loom large. Initially, markets anticipated multiple rate cuts in 2024, which would have favored small caps due to their sensitivity to borrowing costs. However, as rate cut expectations have waned, small caps have remained stagnant.
Despite this, the consensus is that the Fed will cut rates at least once more in 2024, with the possibility of more cuts if inflation data cooperates in 2025. This potential shift presents an opportunity for investors to rebalance their portfolios, increasing exposure to small and mid-cap stocks. Mid-caps, in particular, offer a healthier balance sheet profile, with only 20% of companies unprofitable compared to 42% of small caps.
For now, the dominance of mega-caps continues to shape the market landscape. While timing a “reversion to the mean” is challenging, the prospect of Fed rate cuts is raising some speculation of a potential shift on the horizon. Of course, this isn’t the first time; a move away from U.S. mega-cap tech companies has been heralded as a profitable contrarian trade for nearly a decade now, and it still hasn’t panned out. This time may be different, but even if it isn’t, a professional investor knows the need to consider diversifying holdings amidst a possible sea change, preparing for a market that may soon favor the underdogs.
