The rise of the S&P 500 has mirrored exceptional US economic growth, making it tempting to see it as a direct reflection of that prosperity.
However, is the tide turning? Recent index price declines might be just a minor correction, but beneath the surface, the broader market has been less impressive for some time.
In the first half of 2024, the largest 20 US-listed stocks delivered a 27 percent gain, accounting for three-quarters of the total US market return of 15.3 percent, according to JPMorgan.
Meanwhile, an equally weighted version of the S&P 500 index underperformed the stock markets of every other major region. It lost money in the second quarter. Small-cap stocks, which have a more domestic focus, have fared even worse—although last week they recorded their strongest five-day outperformance of large-cap stocks in at least four decades, according to Goldman Sachs.
Still, the behavior over the past few years has been unusual. Historically, the S&P 500 equally weighted index—where every stock accounts for the same percentage of the benchmark—has tended to both fluctuate with and outperform the main index, where companies are represented in line with their market capitalization. There have only been nine quarters since 1990 when holding an equally weighted basket of stocks lost money in a rising market. Two of these have occurred in the past three years, during which the equal-weighted market has lagged behind by more than five percentage points per annum.
In the context of exceptional national economic growth, this is surprising. Nominal GDP growth of nearly 8 percent per annum over the past three years provided a significant revenue tailwind, an environment where one would expect healthy profit growth. Sales growth across larger companies has more than kept pace, but smaller business revenues have lagged. Overall, smaller company earnings have fallen sharply over the past 18 months, now lower than three years ago.
What accounts for these developments? Higher interest rates help explain the softening fundamentals. Debt-free, cash-rich tech giants only feel the pinch of higher rates when their customers slow orders. More labor-intensive companies carrying debt—which equal-weighted indices better represent—get squeezed not only by higher input costs but also by the policy remedy to them. Monetary policy works by hurting.
Weakening fundamentals across indebted businesses should show up in corporate bond markets. However, credit spreads have continued to narrow across almost all broad tranches of credit quality. This is despite the Federal Reserve’s Senior Officer Loan Survey reporting tighter standards, weaker demand, and higher risk premia on new loans to firms—developments typically accompanied by credit market distress. To square the circle, it appears that management of more indebted companies have been paying down debt where possible, another manifestation of monetary policy working. Where debt reduction has been impossible, such as in the riskiest corner of the US high yield market, spreads of CCC-rated firms have widened, and the default rate has increased, though future expectations are mixed.
Looking forward, softer inflation prints bring hope of monetary policy relief. June’s softer US inflation numbers stoked expectations of a swifter path to rate cuts, boosting bond prices and the stocks of smaller companies.
However, the upcoming US presidential and congressional elections leave questions hanging over the market. Goldman Sachs’ global chief economist Jan Hatzius, presenting to European
Central Bank policymakers in Sintra, analyzed the economic impacts of large tariffs and tax cuts promised by Donald Trump’s campaign. His conclusion was that they would lead to a weaker economy, higher inflation, and a stronger US dollar—typically not good news for stocks.
David Lebovitz, a global markets strategist at JPMorgan Asset Management, argues that it is hard to see a fundamental driver for any extended performance of smaller US companies. A second Trump administration that kept rates higher for longer would more than offset the benefits of protection afforded by tariffs to domestic-facing companies. However, he sees a decent outlook for large-cap businesses in the financial, industrial, and energy sectors as they exit their mini-earnings recessions.
The largest megacap companies have been forging their own path. Their sheer size in capitalization-weighted stock indices has driven overall market returns. Index-based investors may not care where returns have come from, but concentrated gains among a handful of leaders have been hiding broader market softness. While US economic growth has appeared exceptional, the same can no longer be said for most US stocks.
