The Federal Reserve has disappointed investors this year, but that doesn’t matter. The markets have adjusted.
Even without any interest rate cuts so far in 2024 – and with the likelihood of just one meager rate cut by the end of the year – the stock market was humming. That’s quite an accomplishment, given that the Fed was expected in January to cut rates six or seven times in 2024 — and that interest rates across the economy would now be well lower.
As buoyant as the stock market may seem, when you take a closer look, it becomes clear that the S&P 500’s recent returns are on shaky footing.
AI fever – based on the belief that artificial intelligence ushers in a new technological era – has spread among investors, and that has been enough so far to keep overall stock market averages higher. But the rest of the market was rather gloomy. In fact, if we exclude the largest companies, especially technology companies, the overall market performance is not impressive.
Concentrated returns
One stock in particular led the market higher: Nvidia, which makes the chips and other associated infrastructure behind the talking, image-generating, software-writing AI applications that have captured the popular imagination. Over the past 12 months, Nvidia’s shares have soared more than 200%, bringing its total market value to more than $3 trillion, putting it in elite territory shared only with Microsoft and Apple on the American market.
Other giant companies with a compelling AI flavor, like Meta (the holding company of Facebook and Instagram) and Alphabet (which owns Google), as well as chip and hardware companies like Super Micro Computer and Micron Technology, have also performed superlatively in recent times. .
But the narrowness of the stock market rally becomes evident when comparing the standard S&P 500 stock index with a version that contains the same stocks but is less heavy.
First, consider that the standard S&P 500 is what’s called a cap-weighted index, meaning that $3 trillion stocks like Microsoft, Apple, and Nvidia have the most weight . So when these giants rise by 10 percent, for example, they lift the entire index much more than a 10 percent gain by a smaller company in the index, like News Corp., would do. , with a market capitalization of approximately $16 billion.
The standard market-cap-weighted S&P 500 index is up nearly 14% this year, a dramatic gain in less than six months. But there’s also an equal-weighted version of the S&P 500, in which gains of 10% – for giants like Microsoft and just big companies like News Corp – have the same effect. The equal-weighted S&P 500 index has gained only about 4% this year. Similarly, the Dow Jones industrial average, which is not weighted by market capitalization (it has many quirks, which I won’t get into here), only rose about 3%.
A premium on size
In short, bigger is better in the stock market these days. A recent study by Bespoke Investment Group, an independent financial market research company, demonstrates this. Bespoke has divided the S&P 500 into 10 groups, based solely on market capitalization. It revealed that the group containing the largest companies was the only one to post positive returns in the 12 months to June 7. At the same time, the group containing the smallest stocks in the index had recorded the biggest losses.
This pattern was true when Bespoke was only interested in AI companies. Giants like Nvidia saw the strongest returns. Small businesses generally lag behind.
In this calendar year alone, stock indexes that track the largest companies are eclipsing those that track small-cap stocks: The S&P 100, which contains the largest stocks in the S&P 500, is up about 17%. The Russell 2000 index, which tracks the small-cap universe, is up about 1.5 percent for the year.
Even among tech stocks, the bull market doesn’t treat all companies the same. Ned Davis Research, another financial market research firm, said in a report Thursday that if companies that design, manufacture or manufacture equipment for chips (i.e. semiconductors) in the S&P 500 are performing wonderfully, all other tech sectors are lagging the index this year. .
Implications for investors
Although I pay close attention to these developments, I try not to worry about them as an investor. In fact, I view today’s market concentration as a vindication of my long-term strategy, which is to use low-cost, broadly diversified index funds to own a share of the overall stock and bond markets. The overall market’s reliance on a small cohort of large companies is fine for me, but that’s only because I’m well diversified. So I don’t care much about which part of the market is strong and which is not.
As for my own portfolio, I’m also not very worried about the problems that inflation and high interest rates are causing in the bond market.
It’s worth noting that bond interest rates are set by traders who have responded to the Fed’s restrictive monetary policy and stubborn inflation this year by offering higher long-term interest rates – not lower, as had been widely anticipated.
Higher rates are a problem because when bond yields (or rates) rise, their prices fall, according to basic bond calculations. Bond mutual fund returns are a combination of income and price changes. Although higher yields generate more income, they hurt bond prices. Many investment-grade mutual funds are treading water this year, as is their main benchmark, the Bloomberg Aggregate Bond Index.
My own funds follow this index. I am not making any real money from my bond funds and have not for several years. But they generally provide ballast and stability to my portfolio. I’m not thrilled with what’s happening to the bonds, but I can live with it.
On the other hand, if you are an active investor betting on individual asset classes, stocks or sectors, you have a lot to think about right now. You can bet on the continued momentum of the biggest stocks – or even just one, Nvidia. Of course, you might think it’s smarter to go completely the other way. You may want to look for stocks that have been overlooked in this narrow bull market – stocks with lower market caps and what appears to be higher value, based on metrics like their price-to-earnings ratio.
Historically, small-cap value stocks have outperformed large-cap growth stocks over long periods of time, although this has not happened recently. Maybe it’s time for a change of heart? As you change your investments, you may also conclude that bonds and bond funds are a waste of time, compared to the stock market and its more spectacular gains.
Make the right decisions on any or all of these issues and you could make a lot of money. Some people definitely will. But if you make a mistake now – or later, even after making incredibly lucrative bets – you could easily end up losing most of your money.
What the Fed does next will also matter a lot if you’re inclined to make active bets in the market. Persistent inflation convinced policymakers last week that they needed to keep the federal funds rate at around 5.3 percent – high enough, according to the central bank’s estimate, to gradually lower the rate. inflation. There was some good news on this front, with producer prices falling and the consumer price index falling slightly in May, to an annual rate of 3.3 percent, from 3.4 percent previously – but too high for the Fed’s comfort.
The futures market predicts that at the Fed’s July meeting, which falls right between the Republican and Democratic conventions, it will keep rates where they are. But most traders are betting the Fed will cut rates in September. This could trigger a broader rally in the stock market, as well as bonds. With the national election in November, a September Fed cut would undoubtedly please President Biden and, I suspect, displease former President Donald J. Trump, who is known for expressing his feelings vehemently.
There’s a lot to think about, so much so that it’s impossible to know in advance what the best short-term decisions are.
So I’m playing the long-term percentages, based on plenty of academic research suggesting that most people, most of the time, are better off letting the overall markets make money for them. Keep costs low with index funds; hold stocks and bonds at all times, in a reasonable proportion according to your needs and your risk tolerance; and try not to worry too much about all these complex issues – not in your investing life, anyway.
I don’t know what the Fed will do next, and even if I care, I won’t let it influence me financially. The bond market has been weak. The stock market isn’t entirely stable, but that’s okay too. I expect painful losses ahead, but greater gains for those who simply stay the course.