It is the mega-caps’ market and other stocks are just living in it

This year’s rally in US equities has been extremely narrow, essentially being driven by a handful of mega-cap stocks and mostly from the ones that have some  tie-in to the AI thesis.  As of this writing, the “Magnificent 7” which were last year’s stock market darlings, have returned an eye opening 45% YTD.  This would be even higher if we excluded the laggard of the group, Tesla, which is essentially flat for the year.  In comparison, the S&P 500 has returned a more modest, but still respectable, 16%.  However, much of those gains come from the mega-caps, to wit: the equal-weight S&P 500 index has returned a measly 4.7% this year.  Even worse, the Russell 2000 is barely positive with a return of just 1%.    

It’s not that gains can’t be found outside the mega-cap space, but there are few of them with impressive returns on par with the mega-caps and most of them are beneficiaries of investors hunger for AI.  There have been multiple times this year where it seemed that a rotation out of the mega-caps and into the broader market was starting, but each time it seems that investors positioned for a change in the trend have been left disappointed.

Although it seems reasonable to believe the market is overdo for a rotation out of mega-caps, we need to analyze why this small group of stocks have been so successful this year.  Fundamentally, stocks trade on a multiple of their earnings and investor expectations of the growth rate of those earnings is what determines what that multiple will be.  That being said, the bulk of the earnings growth for the entire S&P 500 has been provided by that small group of mega-cap companies, which is a big reason why investors are concentrated in those stocks. It also explains why each time those stocks have had a minor pullback on no news, investors step in and buy the dip.  It becomes a different matter when there is a fundamental downshift in business expectations for these stocks such as we saw happen in 2022.   

There is a lot working in the market’s favor, but it is clear the market is playing favorites, and, in doing so, has invited some rebalancing opportunities for long-term investors in other parts of the market that have been left behind. The balance of power, though, remains with the mega-cap stocks given how much weight they carry.

_{Date of report: July 10th 2024}