Source:Wu Zhijian's empiricism.
In the past year (as of May 31, 2024), the U.S. stock market has performed very well, rising 27.8% in just 12 months. Considering that the Federal Reserve's benchmark interest rate is still high (5.25%-5.5%) and there are no signs of an interest rate cut in the short term, this increase has taken many stockholders by surprise, completely unexpected.
However, many people also point out that the significant feature of the U.S. stock market's gains in the past year is that the gains mainly come from the largest companies by market capitalization, which are$Apple (AAPL.US)$, $NVIDIA (NVDA.US)$, $Microsoft (MSFT.US)$, $Alphabet-A (GOOGL.US)$ and $Amazon (AMZN.US)$. As of the end of May 2024,$S&P 500 Index (.SPX.US)$The total market capitalization of the 10 largest companies in the middle is 35.4% of the total market capitalization of the index, the highest level in the past 30 years. The total market capitalization of the top 25 companies is the same as that of the remaining 475 companies, each accounting for half of the total.
In fact, even among the top 10 largest companies by market capitalization, the differentiation gap is still significant. The must-mention "phenomenal" stock here is Nvidia. Since the beginning of this year, as of June 18, 2024, Nvidia's stock price has risen by 173.8%, while the S&P 500 index has risen by only 15%, and the small cap index has fallen by 0.1%. That is to say, the gains of large-cap stocks in the United States are far higher than those of small-cap stocks, and among large-cap stocks, Nvidia's gains are far ahead of other large-cap stocks.$Russell 2000 Index (.RUT.US)$This situation has led to much higher valuations for large-cap stocks than for small-cap stocks in the U.S. stock market. For example, as of the end of May, the median P/E ratio of the top 10% of the market capitalization of the S&P 500 index was 21.9 times, while the median P/E ratio of the bottom 10% of the market capitalization was around 15.3 times, about 30% cheaper than the former.
Therefore, some investors have raised the following question: Should they consider buying some U.S. small-cap stocks? Currently, what are the reasons for or against buying small-cap stocks? We will analyze this issue below.
First of all, if you buy small-cap stocks, you can hedge the risk of "Nvidia" in the large-cap stock portfolio. Nvidia is the biggest winner of this round of investment in the theme of "artificial intelligence" that has sparked a bull market in the U.S. stock market. Currently, artificial intelligence is still in a honeymoon period with investors, and it is a popular track that many investors are most bullish on. However, experienced investors surely understand that this kind of honeymoon period will sooner or later come to an end. When the hype subsides, Nvidia and a host of other artificial intelligence stocks will roll back, even in a big slump, which may be a disaster for the large-cap stock portfolio. In that case, holding some small-cap stocks should help reduce the portfolio's pullback.
Based on the rise in the past over one year, the market capitalization of U.S. large-cap stocks is heavily concentrated in the information technology and communications industry. For example, in the Russell 1000 index (Note: the largest 1,000 companies by market capitalization in the U.S. stock market), the information technology industry accounts for as much as 38% of the market capitalization, with an average P/E ratio of around 40 times. In contrast, the information technology industry's market capitalization in the Russell 2000 index (Note: companies ranked 1001-3000 by market capitalization in the U.S. stock market) accounts for about 20% of the total market capitalization, only half of that in the Russell 1000 index. Therefore, relatively speaking, the market capitalization distribution of small-cap stocks is more evenly distributed, without the problem of overconcentration in the information technology industry.
Secondly, the valuation gap between small-cap and large-cap stocks is very obvious, approaching the most disparate level in history. As of May 31, 2024, the average forward P/E ratio of the Russell 2000 index is about 27% cheaper than that of the Russell 1000 index. This valuation gap is close to the largest difference since 1990, second only to the valuation gap on the eve of the bursting of the Internet bubble in 1999. If the mean reversion law still works, then we have reason to believe that the valuation gap between large-cap stocks and small-cap stocks will eventually narrow.
Historically, when the valuation gap between small-cap and large-cap stocks widens, the subsequent share price performance of small-cap stocks tends to outperform that of large-cap stocks. For example, the regression statistics of scholars (Fang, 2024) show a significant negative correlation between the valuation gap between large-cap and small-cap stocks and the difference in stock price returns in the following decade. The larger the valuation gap, the worse the performance of large-cap stocks relative to small-cap stocks in the following 10 years.
Thirdly, historical statistics show that when the US economy enters a period of central bank interest rate cuts, small-cap stocks tend to outperform large-cap stocks. Statistical analysis based on the past 40 years (1/1984-5/2024) shows that the difference in stock price returns between small-cap and large-cap stocks is significantly negatively correlated with changes in the central bank's benchmark interest rate. In other words, once the Fed begins to cut interest rates, it is likely that the performance of small-cap stocks will exceed that of large-cap stocks during the same period.
Fourthly, relatively speaking, small-cap stocks have stronger resistance to "anti-globalization." Since the disintegration of the former Soviet Union in 1991, the global economy has gradually entered the "globalization" phase, with cross-border capital, international trade, and talent flowing between countries around the world. One of the biggest beneficiaries of this phenomenon is the large-cap stocks of the US stock market. However, after Trump became the US president in 2016, "globalization" began to reverse, and trade frictions between countries gradually escalated, giving rise to more and more punitive tariffs. An important part of "anti-globalization" is "America First," which requires US companies to stop or reduce outsourcing and bring more production capacity back to the United States. This trend is more bullish for small-cap stocks. For example, in the Russell 1000 Index (large-cap stocks), about 40% of US company revenue comes from markets outside the United States. In contrast, in the Russell 2000 Index (small-cap stocks), US companies' revenue from international markets outside the United States only accounts for 24%, much less than that of large-cap stocks. Therefore, if the "anti-globalization" trend continues, especially if Trump is re-elected as US president in November, small-cap stocks may be stimulated and perform better than large-cap stocks.
In summary, in addition to large-cap stocks, investors may consider allocating some small-cap stocks. Of course, the above analysis only points out the relative attractiveness of small-cap stocks' fundamentals compared to large-cap stocks, but these analyses cannot tell us when these fundamental advantages will translate into stock price returns. That is to say, it cannot help us with timing. As a rational investor, we should still remember the principle of diversified investment and not overly concentrate our investments in a few stocks or only in large-cap stocks, but rather diversify our eggs in different baskets, both large-cap and small-cap stocks, and ensure that our investment portfolio includes different types of assets such as stocks, bonds, and real estate, in order to effectively respond to unpredictable economic cycles and changes in central bank policies, and achieve better risk-adjusted returns.
Editor/Emily