Major stocks gained as markets rose. They win again on sale.

One of the biggest concerns during the rise in stock prices in the first three months of the year was that the rally was dominated by the largest companies. When the market sold out this month, the market became even top-heavy. Blame it on the Fed, and a change in the way investors react to it.

One of the biggest concerns during the rise in stock prices in the first three months of the year was that the rally was dominated by the largest companies. When the market sold out this month, the market became even top-heavy. Blame it on the Fed, and a change in the way investors react to it.

This is not how it should have been. Wall Street has been pushing for weeks now on the idea of ​​the market expanding beyond the ‘Magnificent Seven’ Big Tech stocks, helped by the dismal performance this year of the previously stellar Tesla (-41%) and Apple (-14 %).

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This is not how it should have been. Wall Street has been pushing for weeks now on the idea of ​​the market expanding beyond the ‘Magnificent Seven’ Big Tech stocks, helped by the dismal performance this year of the previously stellar Tesla (-41%) and Apple (-14 %).

It may be broader than seven stocks, but bigger remained better in April, with the notable exception of Friday, when some of the largest stocks tumbled. Divide the S&P 500 into ten groups and there is a near perfect decline in performance by size: from the largest 50 with a loss of just 4.5%, to the smallest 50 with a loss of 8.6%. The pattern is more regular than in the first three months of the year, when the big ones clearly got bigger.

This is not just about the S&P, which after all consists of the approximately 500 largest stocks. The Russell 2000 index of smaller companies lagged badly on its way up, rising less than 5% versus 10% for the S&P in the first quarter. During this month’s decline, the Russell 2000 fell further, down 8.3%, versus a 5.5% decline for the S&P. The Russell Microcap Index, which includes even the smallest companies, rose even less and fell even more.

The main cause is interest rates, plus recently fears of a wider war in the Middle East. Both hurt smaller companies much more than larger ones – and for some larger companies, higher rates even boosted profits.

The impact of higher interest rates is part of the two-speed economy that results from sharp interest rate increases and this year from the evaporation of hopes for multiple rate cuts. Big companies are insulated from the impact of higher interest rates because they used their easy access to the bond markets to hold super-cheap debt for long periods of time when rates were low. Many of the very largest, especially Big Tech stocks, are also sitting on huge piles of cash, earning more thanks to interest rate hikes.

Smaller companies, on the other hand, find it difficult to issue bonds and borrow much more at a variable interest rate. As with poorer consumers who borrow on their credit cards, the cost of this debt has skyrocketed as the Fed tightened policy, hurting the profits of smaller companies. Analysts at Goldman Sachs calculate that nearly a third of Russell 2000 debt has a floating rate, compared with 6% for the S&P 500.

In addition, smaller companies as a group have higher debt levels compared to profits and earnings are more volatile, making them less attractive when there is a flight to quality amid war fears.

This is all reflected in the fact that the Russell 2000 is moving strongly in the opposite direction of bond yields. Meanwhile, there has been no correlation between the movements of bond yields and the top 50 stocks this year – an unusual split between the two indices.

Surprisingly, the excitement about artificial intelligence doesn’t explain the gains of the biggest stocks. Sure, giant chipmaker Nvidia is up 91% this year to its peak on March 25, but it’s down 15% since then, including a 10% drop Friday, far worse than the Russell 2000. Just as it has slowed the performance of big stocks in the first quarter, it should have pulled them down this month, but they still beat their smaller brethren. Furthermore, AI cannot explain why there is such a nice pattern of outperformance in terms of size. This isn’t just about a handful of big AI winners.

The pattern is surprising to anyone who remembers 2022 and suggests that investors are now much more profit-oriented. In 2022, Big Tech and other growth stocks were crushed as valuations collapsed, even though earnings were fine. The argument – ​​a good argument – ​​was that the gains for growth stocks are further in the future than for cheap value stocks, and so higher yields on long-term bonds should make those future gains less valuable. A bird in the hand is worth more if it produces a safe yield above 4% than at 0%, so those two in the bush become less attractive.

The difference this time is that the rates were high to begin with. The 10-year government bond lost almost 20% in price in 2022 as interest rates rose, while interest rates fell only 6% this year. At the time, investors were selling much more growth than value, without much regard for size (both the largest and smallest members of the S&P performed poorly). This year, investors bought more growth than value, while size was more important.

This makes sense. In addition to the fact that interest rate changes have a smaller impact when interest rates are already high than when they are super low, investors have become aware of the varying effects of higher interest rates on the bottom line. Although valuations are still very high, they are also lower than at the end of 2021. That does not make profits on large shares any easier for investors who continue to hope that smaller shares will one day prove their worth.

Write to James Mackintosh at [email protected]

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