By Ellen Hazen, CFA®, Chief Market Strategist
February Takeaways:
- Strong US labor market. January new nonfarm job creation was very strong at 353,000, nearly double the 185,000 estimate
- Inflation declines moderating. Inflation (as measured by the Consumer Price Index, or CPI) was a little higher than expected, at 3.1% vs. expectations of 2.9%
- Rate cut in second half of 2024, at earliest. A veritable parade of Federal Reserve officials has given speeches suggesting that the Federal Open Market Committee is unlikely to cut interest rates before the second half of the year. Consequently, the number of 0.25% rate cuts priced into the market for 2024 has declined from 6 cuts a couple of months ago to only 3 cuts now
- Large company Q4 2023 earnings growth 7%. Corporate earnings for Q4 2023 have mostly been reported, with average revenue growth for the S&P 500 Index companies at 4% Y/Y, and average earnings growth for those same companies at 7% Y/Y.
- Large companies have faster-growing earnings. Smaller companies’ earnings growth has been materially below that of large companies. As measured by the S&P 600 Small Capitalization Index, average revenue for Q4 2023 grew by only 1% Y/Y, and average earnings declined by 21%. This decline was widespread across economic sectors: small company earnings in the energy sector declined by 37%, while those in the technology and consumer staples sectors declined by 25%, and those in the healthcare, financials, and real estate sectors declined by 20-21%
What We Are Watching In March:
- Nonfarm payrolls for February will be reported on March 8. Consensus is expecting 180,000 new jobs, much lower than the actual number reported in January. We expect the jobs market to remain strong for the rest of 2024
- Interest rates. Fed officials will meet on March 19-20. We expect that they will hold the Federal Funds rate steady at the 5.25-5.5% range
Equity indices in the US have continued the upward trajectory from 2023. The large-capitalization S&P 500 Index has appreciated by 7.1% in the first two months of the year. If this pace of appreciation were to continue for the rest of the year, annual returns would be over 50% – clearly not the most likely scenario. Thus, we expect some volatility in equity markets as markets weigh the likely positive trajectory of the economy and corporate earnings against current valuations.
Reflecting the lower earnings, small-capitalization companies have not fared nearly as well as large company stocks. Through the end of February, the S&P 600 Small Capitalization Index declined by 0.8%.
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One historical era that may serve as a parallel to today is the 1994-2000 period. During that seven-year period – as the internet was being built out – large cap companies outperformed their smaller cap brethren in 6 of 7 years. |
Large Company Stocks vs. Small Company Stocks
A curious phenomenon has developed in markets around the world over the past two years: large company stocks have noticeably outperformed small company stocks. Indeed, the scale of this large company outperformance over the past few years has been so large that one could be forgiven for thinking, “But hasn’t that always been the case?” In fact, no.
Back in 1981, University of Chicago graduate student Rolf Banz published a paper identifying what became known as the “small cap premium.” His work showed that smaller companies had systematically higher risk-adjusted returns than larger companies. This research was subsequently replicated by other practitioners and was an exploitable market anomaly for many years.
Why would smaller companies outperform larger companies? There are several possibilities. First, they are not subject to the “law of large numbers.” They can grow at accelerated rates for many years before becoming so large that growth becomes difficult. Second, smaller companies can participate more purely in narrow market niches that may themselves be rapidly growing. Third, smaller companies are often more nimble and more easily able to adapt to changing market conditions than large companies.
If we look at history, we see that in the US, in Europe, and in Japan, small cap company indices did indeed outperform in most calendar year periods over the 25 years. In particular, from 2000 to 2018, small cap stocks outperformed large cap stocks in the US, Europe, and in Japan. But since 2018, large cap stocks have dominated in all regions. What has happened?
*2007-2018
US Large Cap = S&P 500 Index ;US Small Cap = S&P Small Cap 600 Index
Europe Large Cap = EURO STOXX 50 Index; Europe Small Cap = MSCI Europe Small Cap Index
Japan Large Cap = TOPIX Core 30 Index; Japan Small Cap = S&P Japan SmallCap 250
Source: Bloomberg Finance, L.P.
The first part of this post-2018 period was dominated by the network effect of large internet companies. These companies benefitted from a winner-take-all or winner-take-most dynamic where the larger the company, the more market share it was likely to gain. In 2020 through 2022, large internet platform companies were perfectly positioned for the effectively overnight pandemic-driven move of much of the corporate world to a virtual workspace. Finally, the last year or so has been dominated by investor excitement around artificial intelligence, which again is skewed more toward the largest companies. These are the companies that can afford to spend billions on the expensive chips and software necessary to train artificial intelligence algorithms.
You can see this in earnings estimates. In the US, large company earnings are expected to grow this year by 9%, while small company earnings are expected to grow by 4.5%. In Europe and Japan, however (which are much less dominated by internet companies), small cap stocks are expected to outgrow large cap stocks both this year and next year. Thus, the era of globally large-cap dominance may be over – it may continue in the US, but it is not obvious that it will continue in the rest of the developed world.
| Earnings Growth Estimates | |||||||||||
| US | Europe | Japan | |||||||||
| 2024 | 2025 | 2026 | 2024 | 2025 | 2026 | 2024 | 2025 | 2026 | |||
| Large Cap | 9% | 12% | 11% | -1% | 8% | 7% | -1% | 7% | 12% | ||
| Small Cap | 4% | 15% | 10% | 42% | 37% | 10% | 15% | 11% | 1% | ||
US Large Cap = S&P 500 Index ;US Small Cap = S&P Small Cap 600 Index
Europe Large Cap = EURO STOXX 50 Index; Europe Small Cap = MSCI Europe Small Cap Index
Japan Large Cap = TOPIX Core 30 Index; Japan Small Cap = S&P Japan SmallCap 250
Source: Bloomberg Finance, L.P.
What does this mean for the future? History is characterized by pendulum swings. Some of the largest and best-performing companies from years past have lost their competitive edge and gone on to underperform. Examples include General Electric, AT&T, and Corning. It could be that small cap companies will shine in the near future.
At the same time, dynamic capitalism depends in part on small companies’ ability to effectively compete with their larger brethren. In recent years, the number of antitrust cases brought by the Department of Justice has declined, potentially giving large companies more freedom to use their scale to maintain market share.
One historical era that may serve as a parallel to today is the 1994-2000 period. During that seven-year period – as the internet was being built out – large cap companies outperformed the smaller caps in 6 of 7 years. If artificial intelligence is built out in a similar fashion, we could see several more years of large company stocks outperforming.
The valuation discrepancy between large cap and small cap indices is fairly wide at this point, suggesting that when small caps do start to outperform large caps, the magnitude could be sizable. At the same time, we have seen large caps outperform for long stretches historically, particularly when a major technology transition is underway. Will that prove to be the case this time? The higher expected growth rates for large companies – at least in the US – could indicate this. We will continue to closely watch growth dynamics in both segments.