Dear Reader,
Welcome to our latest edition of Market Insights with Sanjeev Kaushik. As we navigate the complexities of the US financial markets, we have observed several pivotal trends and shifts lately that have prompted a strategic reevaluation of our trading and investment approaches.
Our goal is to provide you with ways to demystify market dynamics but also offer actionable insights that inform your investment decisions.
Today at a glance:
- Sell in May? Not This Year
- Capital Concentration in Mega Caps
- Why Big Names Win Big
- Underperformance of Small Caps in US
- How Does this Help You?
- From The Vault
‘Sell in May and Go Away’ Failed Again!
May ended at all-time highs despite the fact that it tends to be among the weakest performing month of the year. Once more, the familiar saying “Sell in May and Go Away” proved unsuccessful. This strategy is commonly embraced by those who adhere to seasonal patterns, opting to sell in May and repurchase in October. Surprisingly, this timing-based approach has yielded impressive results on occasion, contributing to a reasonably favorable overall track record.
But there is one anomaly to this rule and that relates to S&P 500 making all-time highs in May. Every time May ends with all-time highs on the index, the rest of the year tends to generate positive return. Such instances have been observed five times in the last 10 years and S&P 500 closed the year with gains each time. Therefore, selling in May to return back in October can often time means buying at levels higher than the exit points.
Capital Concentration in Mega Caps
Unfortunately, this bull market just like the previous ones hasn’t benefitted all the stocks uniformly. Once again, bulk of the buying is limited to mega caps, and such has been the trend in US markets for a very long time. All the highs made in S&P 500 & Nasdaq indexes can be entirely attributed to the mega tech stocks barring a few exceptionally well-run firms from a select few sectors.
*Market Capitalization (M-CAP) as of June 14, 2024
Overall, it’s the Technology (XLK) and Communication (XLC) sector that has been at the forefront of every bull run with the mantle briefly handed over to other sectors such as Healthcare (XLV) during the pandemic and Energy (XLE) during early 2022 due to the beginning of Russia-Ukraine war leading to spike in energy prices.
Why Big Names Win Big
Here’s a list for some of the reasons why capital in-flows get concentrated into big names even during best of the bull markets:
- Index (ETF) Investing: Nasdaq and S&P 500 are market cap-weighted indexes i.e. the larger the company the more weightage it carries in the index and therefore, mega caps receive higher share of passively invested funds into their stocks.
- Big but Passive: Barring a few active hedge-fund managers, most deep pocketed investors prefer the comfort of mega caps that can safely emulate index returns instead of actively looking for undervalued stocks in mid or small cap space and take additional risk to generate outperformance. These investors generally belong to pension or sovereign funds category with low risk appetite as their primary goal is usually tied to capital preservation.
- TINA (There Is No Alternative) Effect: Because these stocks have performed well in the past and an average investor knows no better than investing in the commonly heard companies. For instance, most people still buy Apple as their first stock after opening their brokerage accounts. The new money tends to first flow into their stocks until the investor gets comfortable with risk taking and looks to diversify in other lesser-known names.
- Strong Fundamentals: Despite the overwhelming concentration of invested funds, there is no denying the fact that the mega caps are amongst the best run companies in the world boasting strong balance sheet, cash flows as well as expanding earnings per share for their investors. So naturally, they deserve to get the lion’s share of every dollar poured into the US markets.
Given the reasons enlisted above, it is highly unlikely that small and mid-cap group of companies will be able to outperform the index heavy weights in future even when as we gradually move towards the era of low interest rates.
Granted, there will be exceptions where a small cap doubles in a day or week due to corporate action, strong earnings and/or future guidelines or any other reason but actively finding them is akin to looking for needle in a haystack and foregoing the assured index returns in the pursuit.
Why Big Names Win Big
Firstly, let me showcase the relative underperformance of the small caps with the help of the chart below. This is a ratio chart of Russell 2000 (RUT: Small cap index) and S&P 500 (SPX: 500 biggest US companies) calculated based on the monthly closing levels of each of the indexes.
Ratio Chart: RUT/SPX (Source: Tradingview)
Mathematically speaking, because this is a ratio chart of two mutually exclusive price series (RUT divided by SPX); in order to witness outperformance of RUT over SPX, we must see the graph moving upwards implying sustained outperformance for a long enough period to justify investing in small caps. However, as the purple arrow shows, the small cap index has been mostly underperforming the S&P 500 since 2013 and is showing no signs of revival at this stage.
Granted, we may see some outperformance coming back as monetary policy loosens but I doubt the viability of such strength over a longer period of time. Small caps will start fizzling out at the very first sign of the next slowdown in the economy just like we saw a blip of outperformance during the brief bull market of 2020-21 shown by the two red arrows followed by another sustained period of underperformance lasting till date.
Put simply, this graph is telling us that we must tamper down our expectations of a roaring bull market in small caps due to favorable US monetary policy.
While we have had decent results in our investing journey so far yet personally, I felt the rally in small caps stocks fizzled more often than it did in large cap stocks. The performance of some Australian small cap stocks is even more disappointing despite ASX 200 trading near all-time highs.
Worst still, we ended up giving back gains in some counters after a decent run up because we stayed invested in the anticipation of achieving targets. Sometimes, the falls were so sharp that we had to cut loose the position in losses despite being in profits at one time.
Such volatile moves may seem like a paradise for short-term trader but for us investing with a longer-term view, it meant parking capital in an underperforming counter while we helplessly saw the index making new highs every other month.
How Does this Help You?
The underperformance of small caps leaves a very small room for error but if you are an experienced stock picker then it shouldn’t bother you much. However, when deciding between a large and a small cap stock to invest, the choice becomes obvious!
In the absence of passive ETF investors’ funds going into the small cap space, it is mainly the fundamentals and corporate events that drive the small stock higher. Even if small caps started to outperform, one cannot expect the momentary shoot up to last for a stretched period (24 months or more). This makes exit timings even more important that the entries.
Personally, considering the comfort of large and mega cap stocks, I am actively pursuing investment opportunities in S&P 500 components. These stocks not only have better earnings visibility, but they also relatively benefit more from passive fund flow into the index than the small caps.
