By Ellen Hazen, CFA®, Chief Market Strategist

March Takeaways:

• Jobs are still strong. The US unemployment rate has remained steady at 3.9% for two months, while the US economy added 275,000 new nonfarm payroll jobs in the month of February, ahead of expectations. The labor force participation rate has been 62.5% for three months, and remains below the pre-pandemic high of 63.3%, driving upward wage pressure
• Inflation has stabilized but is no longer declining. The most recent Consumer Price Index (CPI) report of 3.2% was modestly higher than expectations of 3.1%, while the Personal Consumption Expenditure Core Price Index (PCE) report two weeks later was in line with expectations at 2.8%
• The Fed left rates unchanged. At its March meeting, the Federal Reserve left the Federal Funds Rate unchanged, but increased its GDP and inflation estimates for the next two years. There was little discussion of any change to the pace of balance sheet taper
• The Equity market broadened in March. Equal-weighted and value indices outperformed in the month, while small-cap stocks kept pace with the large-cap index. Other measures of breadth (e.g., the percent of companies above their 50-day moving averages) were more positive in the large-cap indices than in the small-cap ones
• The Magnificent Seven performance diverged further. Year-to-date, the best-performing of the Mag7 (Nvidia) is up 82%, while the worst-performing (Tesla) is down 29%
• Rates rose slightly. The yield curve was nearly unchanged in the month. The 10-year yield increased from 4.18% to 4.20%. Most bond index total returns are slightly negative year-to-date

What We Are Watching In April:

• Earnings. Companies will start reporting Q1 2024 earnings in mid-April. Currently, consensus estimates for the S&P 500 Index reflect earnings growth of 8.6% for the quarter and 9.1% for the full year 2024. At this point, we believe estimates have declined sufficiently and do not expect material decreases
• Nonfarm payrolls for March will be reported on April 5. Consensus expects 205,000 new jobs, somewhat lower than the 275,000 reported for February. We expect the jobs market to remain strong throughout 2024
• Fed meeting April 30-May 1. We expect the Fed to hold rates steady and continue the current balance sheet taper pace of $95 billion per month
• Will the equity market broaden beyond the large-cap space? The equity market’s narrowness in 2023 and early 2024 has been well-discussed, with just a handful of stocks contributing most of the index-level returns. Will the increased breadth observed in March spread to smaller stocks?

Breadth in large stocks. After struggling in January and February, the equal-weighted S&P 500 Index outperformed the market capitalization-weighted S&P 500 Index in March. The equal-weighted index returned 4.5% while the cap-weighted S&P 500 Index returned only 3.2%. Both outperformed the Magnificent Seven (Nvidia, Meta, Amazon, Microsoft, Alphabet, Apple, and Tesla), which on average appreciated just 1.1%. This is a departure from the first two months of the year when the Mag7 outperformed the S&P 500 Index, which in turn outperformed the equal-weighted index. In March, value stocks also outperformed growth stocks: the Russell 1000 Value Index (5.0%) handily outpaced the Russell 1000 Growth Index (1.8%). In our view, the outperformance of both the equal-weighted and the value indices illustrate a healthier dynamic than the dominance of just a handful of stocks as was observed in both 2023 and in the first two months of 2024. Looking beyond large-cap companies, the S&P Small Cap 600 Index kept pace with (but did not outperform) the S&P 500 Index in March, returning 3.2%, after having underperformed in both January and February.  We believe that the breadth in the large-cap space is likely to continue, but we are not as confident that this breadth will spread to the small-cap space.

Strong economic data has led to higher inflation and higher rates. Over the past year, economic data has been generally coming in stronger than expectations. Some examples include labor market metrics (January jobs created were 168,000 above expectations and February jobs created were 75,000 above expectations) and existing home sales (both January and February results were ahead of expectations). One weaker area had been the Manufacturing PMI (Purchaser Managers’ Index), which had been below the neutral 50 level since October 2022. However, even the PMI recently crept into expansionary territory with a March reading of 50.3, broadening the constellation of positive economic data.

This stronger data has corresponded with (and perhaps driven) higher-than-desired inflation, which in turn has led the Fed to become somewhat more hawkish, signaling that they are likely to keep interest rates higher for longer. After sharply declining from a peak of 9.1% in mid-2022, the widely watched CPI has stubbornly remained between 3.2% and 3.7% since June of 2023. In turn, at the Fed’s March 2024 meeting, participants increased their collective projected Federal Funds Rate estimate for 2025 from 3.6% to 3.9% and increased their 2024 PCE estimate from 2.4% to 2.6%.

Smaller companies are hurt more by higher rates than larger companies. We observe that over the past year, the negative correlation of the S&P Small Cap 600 Index to 10-year bond rates is relatively strong at -0.4 (meaning when interest rates go up, small cap stocks tend to go down), while the correlation of the S&P 500 Index to 10-year bond rates is much lower at -0.1. This intuitively makes sense because smaller companies in aggregate have higher debt levels than larger companies. Average net debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) is three percentage points higher for the S&P Small Cap 600 Index than for the S&P 500 Index. Moreover, more small company debt is floating rate debt than at large companies (33% vs 20%), and thus small companies are more immediately negatively impacted by higher interest rates.

Small company earnings revisions are negative. Small companies are faring worse than large companies on the earnings front as well. Earnings estimates for the smaller-company S&P Small Cap 600 Index have in fact declined over the past several months by about 6%, while those for larger companies have remained flat.

In our view, this differential in earnings growth underpins the lack of market broadening beyond the largest companies. Twice in the past year small-cap stocks have outperformed large-cap stocks, only to underperform in subsequent months. For example, despite those fleeting outperformances by small caps, large caps have outperformed small caps by 14% during the trailing 12 months, returning 30% vs. 16%.

Most of the recent appreciation in both large and small stocks has been due to multiple expansion (price-to-earnings ratios rising) rather than earnings growth. For example, while S&P 500 Index earnings estimates have not increased, the price-to-earnings ratio based on expected earnings has increased from 17.7x in October of 2023 to 21.0x now. Similarly, the price-to-earnings ratio based on expected earnings for the S&P Small Cap 600 Index has increased from 12.1x in October of 2023 to 15.5x now.

In conclusion, it is hard to expect significant broad market appreciation in the small cap space, given that earnings estimates are declining and that the increasingly likely higher-for-longer interest rate regime disproportionately hurts smaller companies. While smaller stocks are notably less expensive than larger stocks, we believe it is unlikely that price-to-earnings multiples will expand while earnings estimates are declining. Thus, we believe that small caps will continue to underperform large-caps in the near term, even as broadening within the large cap space – to value stocks and to “the other 493” stocks – is likely to continue.

Disclosures