The Federal Reserve has disappointed investors this year, but that doesn’t matter. The markets have adjusted.
Even with no rate cuts to date in 2024 – and with the likelihood that there will only be a meager rate cut by the end of the year – the stock market continues to purr. That’s quite an achievement considering in January that the Fed would cut interest rates six or seven times in 2024 – and that interest rates across the economy would be much lower by now.
As buoyant as the stock market may seem, if you look closely, it’s clear that the S&P 500’s recent returns are on a precarious footing.
AI fever – based on the belief that artificial intelligence is ushering in a new technological era – has spread among investors, and so far that has been enough to push the overall stock market average higher. But the rest of the market was more hectic. If you ignore the largest companies, especially the technology companies, the overall performance of the market is unimpressive.
Concentrated returns
One stock in particular has led the market higher: Nvidia, which makes the chips and other related infrastructure behind the talking, image-generating and software-writing AI apps that have captured popular imagination. Over the past 12 months, Nvidia shares have risen more than 200 percent, pushing its total market value to over $3 trillion. This makes the company one of the front runners, which it only shares with Microsoft and Apple on the US market.
Other giant companies with compelling AI flavors, such as Meta (the holding company of Facebook and Instagram) and Alphabet (which owns Google), as well as chip and hardware companies such as Super Micro Computer and Micron Technology, have also shown excellent performances recently.
But just how limited the stock market rally is becomes clear when you compare the standard S&P 500 stock index with a version that includes the same stocks but is less top-heavy.
First, consider that the standard S&P 500 is what’s known as a capitalization-weighted index — meaning $3 trillion worth of stocks like Microsoft, Apple and Nvidia have the most weight. So if these giants rise by, say, 10 percent, they pull the entire index up significantly more than a 10 percent increase by a smaller company in the index, like News Corp, with a market capitalization of around $16 billion, can.
The standard capitalization-weighted S&P 500 is up nearly 14 percent this year – a spectacular gain in less than six months. But there is also an equal-weighted version of the S&P 500 in which 10 percent gains – for giants like Microsoft and just large companies like News Corp – have the same effect. The equally weighted S&P 500 has only gained about 4 percent this year. Likewise, the Dow Jones Industrial Average, which is not capitalization-weighted (it has many unique features of its own that I won’t go into here), is up less than 3 percent.
In short, in the stock market these days, “bigger is better.” This is shown by a current study by Bespoke Investment Group, an independent financial market research company. Bespoke has divided the S&P 500 into 10 groups based solely on market capitalization. It found the group with the largest companies was the only one to post positive returns in the 12 months to June 7. At the same time, the group with the smallest stocks in the index recorded the largest losses.
This pattern held true when Bespoke only looked at AI companies. Giants like Nvidia achieved the highest returns. Smaller companies generally lagged behind.
This calendar year alone, stock indexes tracking the largest companies are outperforming those tracking small-cap stocks: The S&P 100, which includes the largest stocks in the S&P 500, is up more than 17 percent. The Russell 2000, which tracks the small-cap universe, is up less than 1 percent for the year.
Even when it comes to technology stocks, not all companies are treated equally in a bull market. Ned Davis Research, another financial research firm, said in a report on Thursday that while companies in the S&P 500 that design, manufacture or produce chips (also called semiconductors) are doing well, all other technology sectors are underperforming the index this year have remained behind.
Implications for investors
Although I’m watching these developments closely, as an investor I try not to worry about them. In fact, I view the current market’s concentration as a validation of my long-term strategy, which is to own a portion of the total stock and bond market with low-cost, broadly diversified index funds. I’m fine with the overall market’s reliance on a small cohort of large companies, but that’s only because I’m well diversified. That’s why I don’t worry too much about which part of the market is strong and which is not.
As for my own portfolio, I’m also not too worried about the problems that inflation and high interest rates are causing in the bond market.
Note that bond interest rates are set by traders, who have responded to the Fed’s tight monetary policy and stubborn inflation this year by offering longer-term interest rates higher, not lower, as was widely expected.
Higher interest rates are a problem because, as bond math goes, when bond yields (or interest rates) rise, their prices fall. Bond mutual fund returns are a combination of income and price changes. While higher yields generate more income, they hurt bond prices. Many investment-grade mutual funds are reeling this year, as is their main benchmark, the Bloomberg Aggregate Bond Index.
My own funds track this index. I don’t make any real money from my retirement funds and have not for several years. But they usually provide ballast and stability in my portfolio. I’m not happy about what happened 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, there is 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 wiser to go completely the other way. You may want to look for stocks that have been neglected in this tight bull market – stocks with smaller market caps and seemingly higher value based on metrics like price-to-earnings ratios.
Historically, small-cap value stocks have outperformed large-cap growth stocks over long periods of time, but that hasn’t been the case recently. Maybe it’s time for a U-turn? As you make changes to your investments, you may also come to the conclusion 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 some or all of these questions and you could make a lot of money. Some people undoubtedly will. But if you make a mistake now – or later, even after you’ve made some incredibly lucrative bets – you could easily end up losing most of your money.
What the Fed does next will also be of great importance if you are inclined to actively bet on the market. Persistent inflation convinced policymakers last week that they need to keep interest rates at around 5.3 percent – high enough, according to the central bank’s assessment, to gradually reduce inflation further. There was some good news on that front: Producer prices fell and the consumer price index fell slightly in May from 3.4 percent to an annual rate of 3.3 percent — but too high for the Fed.
The futures market is predicting that the Fed will leave interest rates where they are at its July meeting, which falls right between the Republican and Democratic conventions. However, most traders are betting that the Fed will cut interest rates in September. That could trigger a broader rally in the stock market and also in bonds. With the national election in November, a Fed rate cut in September would undoubtedly please President Biden and, I suspect, displease former President Donald J. Trump, who is known to be vocal about his feelings.
There is so much to consider that it is impossible to know in advance what the best short-term actions will be.
So I’m betting on the long-term percentages, based on a lot of scientific research that suggests that in most cases, most people are better off letting the overall markets make their money. Keep costs low with index funds; Always hold stocks and bonds proportionate to your needs and risk tolerance. And try not to worry too much about all of these complex issues – at least not in your life as an investor.
I don’t know what the Fed will do next, and while it’s important to me, I won’t let it affect me financially. The bond market was weak. The stock market isn’t entirely stable, but that’s okay too. I expect there will be some painful losses, but bigger gains for those who simply stay the course.
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2024-06-14 20:22:40
www.nytimes.com
