The Big Picture
In the stock market it is a mega-cap world, and every other stock is just living in it. That can be better for some stocks and worse for others, but there is no mistaking in the performance metrics where investor interest is concentrated.
The market-cap weighted S&P 500 is up 13.6% year-to-date as of this writing. The equal-weighted S&P 500 is up 3.5%. The Russell 2000 is down 1.3% and the S&P Midcap 400 Index is up 3.7%.
It's not that gains can't be found outside the mega-cap space, it's just that those gains in general pale in comparison to the returns found among the mega-cap stocks. To wit: the Vanguard Mega-Cap Growth ETF (MGK) is up 20.3% year-to-date.
We've said it before and we'll say it again: for an index investor, it doesn't matter how you get there. The gains count just the same whether they are fueled by a small group of stocks or all 500 stocks. That is true on the way down as much as it is on the way up, but fortunately for investors they are benefiting from a market in an uptrend.
That trend will be their friend... until it isn't. So, with the S&P 500 and Nasdaq Composite trading at record highs, the question now is, what could go wrong to disrupt the trend?
From Right to Wrong
The answers to that important question are embedded in what has gone right:
- Earnings growth has been better than expected, prompting upward revisions to earnings estimates.
- Inflation remains sticky above the Fed's 2% target, but has been trending lower.
- Economic growth remains on a soft landing/no landing track.
- The labor market is loosening from its extremely tight condition but remains relatively strong, which is key for consumer spending activity.
- Market rates, up for the year, have been trending lower since late April.
- The Federal Reserve hasn't closed the door on the possibility of another rate hike, but it has deemed another rate hike as unlikely.
- AI hardware demand is booming, driving a massive capital investment cycle.
- The mega-cap stocks have been invincible as a leadership group.
- The Israel-Hamas War has not turned into a wider regional conflict.
- The Russia-Ukraine War has not turned into a wider regional conflict.
Take the opposite of any of those developments and there will be some disruption for the stock market. How much disruption is dependent on which, if any, of these factors shifts. In turn, there is also the "exogenous factor," which is market parlance for something that takes the market by surprise in a negative way. China invading Taiwan this year would be an example of an exogenous factor.
No matter the surprise or the reversal of fortune of known factors, the market disruption would be proportional to what it is deemed to mean for earnings growth since earnings and earnings expectations drive the stock market.
Both are currently working in the market's favor. If that remains the case, there can still be a correction. The difference, with growth expectations remaining intact, is that pullbacks will be seen as a buying opportunity; however, if a correction is precipitated by a reduction in earnings growth estimates, the conviction to buy on weakness won't be strong.
Riding on Earnings
Another reason earnings growth is so important is that the market's rich valuation is riding on it. The market-cap weighted S&P 500 trades at 20.8x forward 12-month earnings compared to a 10-yr average of 17.8x, which was cultivated over an extended period when interest rates held close to the zero bound.
Interest rates are higher today, but importantly the economy has managed to weather the jump in rates quite well -- so far anyway. Whether there is going to be some lag effect payback remains to be seen, and that is a source of angst relative to the Fed keeping rates higher for longer. The fear is that the Fed will overstay its welcome in restrictive territory and drive the economy into a recession.
That isn't what anybody wants because recessions are bad for employment, bad for spending, and bad for earnings. The average peak-to-trough earnings drop in a recession since 1960 has been about 31%, according to Yale University professor Robert Shiller's data.
Such a drop isn't in the market's immediate forecasting future. According to FactSet, calendar year 2024 earnings are expected to increase 11.6%, calendar year 2025 earnings are expected to increase 14.3%, and the early line on calendar year 2026 earnings suggests earnings are expected to increase 12.0%.
Of course, the bulk of the earnings growth has been provided by the mega-cap companies, which is a big reason why investors are concentrated in those stocks. Their mass appeal among retail and institutional investors alike is why there is often attention paid to the factor of concentration risk.
If they go down as a unit, much like they have gone up as a unit, it would presumably be a problem for index investors -- but it doesn't have to be entirely.
The key is if money rotates away from the mega-cap stocks and into the broader market in a rebalancing trade. Where the disruption for the market would arise is if the mega-cap stocks correct and there isn't a rotation within the stock market. The bigger problem would be if the mega-cap stocks correct as a unit because of a fundamental catalyst.
Stocks that pull back on no news, and only because they have gone up a lot in price, are typically stocks that get bought on weakness. It becomes a different matter when there is a fundamental downshift in business prospects for stocks -- and a market -- trading with rich valuations that rest on a favorable earnings outlook.
What It All Means
From the vantage point of an index investor, things look pretty good. The S&P 500 and Nasdaq Composite have broken new record ground with the mega-cap stocks doing the shoveling. They have effectively set the tone for the rest of the market.
What that means is that the rest of the market has traded more conservatively as money flows have favored the biggest of the big for their earnings power, their financial strength, their leadership positions, and their momentum. It also means the market-cap weighted S&P 500 has been in an uptrend because of their leadership.
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.
Ultimately, they are still beholden to economic trends that will flow from changes in interest rates, inflation, capital investment plans, and geopolitics, all of which have bearing on earnings prospects. Those things have been working in the market's favor -- and their favor -- for the most part, so index investors have had a lot to feel good about when opening 401K and retirement account statements.
When everything feels good, though, is when there should be an appreciation for what can make things feel bad. That's just part of the risk management process, which, at this point, revolves around the mega-cap stocks and earnings estimate trends.
