Is the Era of Mega-Cap Dominance Nearing its End?
By TMC Research Staff | The Milwaukee Company | tmcresearch@themilwaukeecompany.com
The dominance of mega-cap stocks in the US financial markets has been a defining feature of the past decade. Technology companies like Apple, Microsoft, Amazon, Google, and Meta have predominantly driven market rallies and commanded significant portions of market indices like the S&P 500 and NASDAQ Composite. However, recent trends and economic factors suggest that this era may be approaching its twilight. Let's explore the various dynamics at play.
Mega-cap stocks have long been the stalwarts of market growth. Their influence on indices like the S&P 500 has been profound, with these giants often dictating the overall market direction. For instance, the top ten mega-cap stocks account for a significant portion of the S&P 500’s market capitalization, making their performance crucial to the index's overall health (we wrote about the impact of concentration risk in one of our articles published in June).
However, the tide may be turning. Recent performance data indicates that small- and mid-cap stocks are beginning to show signs of life. Since the start of July 2024, the Russell 2000, a benchmark for small-cap stocks, has outperformed the S&P 500, suggesting a potential shift in investor sentiment amid growing concerns that large-cap company valuations appear to be overstretched.
Earnings Slowdown and Shifts in Investor Attention
One critical factor influencing this shift is the modest deceleration in earnings growth among mega-cap tech stocks. Companies such as Amazon, Alphabet, and Meta have seen their revenue growth projections revised downwards, leading to a re-evaluation of their stock prices. In contrast, the earnings growth for many small- and mid-cap stocks appears to be accelerating, drawing more investor interest.
Additionally, the concentration risk associated with mega-caps is becoming more apparent. Many investors are beginning to question whether the valuations of these tech giants are sustainable, especially in a market experiencing rapid economic changes and increased volatility.
Case for Small and Mid-Cap Stocks
Small- and mid-cap companies are uniquely positioned to benefit from several market dynamics. Historically, these firms have been prime targets for mergers and acquisitions (M&A). According to a JP Morgan report, 96% of public M&A targets in the past 30 years have been small- to mid-cap companies, often commanding substantial premiums.
Moreover, small- and mid-cap stocks generally tend to be less covered by analysts, creating opportunities for active stock picking. This lack of coverage can result in mispriced assets that astute investors can capitalize on. The structural inefficiencies in the SMID-cap market make it ripe for generating alpha, especially for investors willing to take on the additional risk associated with these stocks.
Small and mid-cap stocks have also been generally slower to adopt AI compared to their larger counterparts. As AI adoption picks up pace, these companies appear to be positioned to benefit more significantly, providing them with an edge in innovation and efficiency.
Economic and Market Outlook
While mega-caps have benefited from a decade of low-interest rates and high liquidity, the current economic environment has been less favorable. Higher interest rates and a focus on profitability and balance sheet strength are likely to benefit smaller companies with robust fundamentals.
The upcoming earnings season has provided critical insights into the financial performance of mega-cap companies. These firms have been under significant pressure to demonstrate robust earnings growth to maintain their market dominance. However, recent earnings reports from several mega-cap companies have raised concerns among investors about potential signs of weakness.
While some companies have met or exceeded expectations, others have shown signs of struggle, sparking worry about their ability to sustain growth in the current economic climate. This mixed performance highlights the challenges these giants face in an increasingly competitive and volatile market environment.
A recent analysis from JP Morgan suggests that the broadening of the market rally to include small- and mid-cap stocks is generally supported by robust earnings growth and attractive valuations. Despite their recent underperformance relative to large caps, small- and mid-cap stocks have generally grown their earnings at a faster pace over the past decade. This earnings growth has been driven by innovation and streamlined business models, making these companies attractive for long-term capital appreciation.
Furthermore, the near-record valuation discount for high-quality small and mid-cap stocks relative to their large-cap peers creates a potential entry point for investors. According to JP Morgan’s Long-Term Capital Market Assumptions, U.S. small and mid-cap equity returns are expected to be robust over a 10- to 15-year investment horizon, potentially rivaling that of large caps.
Lessons from the Early 2000s
There’s a case to be made that we may be witnessing a situation similar to the early 2000s, where large-cap stocks in the S&P 500 barely grew, but small- and mid-cap stocks performed remarkably well. This historical context underscores the potential for smaller stocks to outshine their larger counterparts during periods of economic transition and market realignment. The chart below illustrates the cumulative returns of large-cap and small/mid-cap stocks from 2000 to 2007 using SPY ETF (as a proxy for S&P 500) and IJR (as a proxy for S&P 600), highlighting the potential for significant outperformance by smaller stocks during certain periods.
The early 2000s were marked by the aftermath of the dot-com bubble burst. Large-cap technology stocks that had led the late 1990s rally faced a significant correction. In contrast, small- and mid-cap stocks, which were not as heavily involved in the speculative excesses of the bubble, found themselves in a more favorable position. The economic recovery that followed was characterized by increased investor interest in these smaller companies, which often had stronger fundamentals and better growth prospects relative to their valuations.
Today, the market appears to be reflecting a similar sentiment. Mega-cap stocks, particularly in the tech sector, have enjoyed unprecedented growth, but their lofty valuations are now being scrutinized. Slowing growth rates and increasing competition are adding to the challenges faced by these giants. Conversely, small- and mid-cap stocks are showing resilience and potential for higher returns, especially as they begin to embrace technological advancements like AI.
The slower adoption of AI by small and mid-cap companies can be seen as both a challenge and an opportunity. While these companies may currently lag behind in integrating advanced technologies, the accelerating pace of AI adoption presents a significant growth catalyst. As these companies begin to implement AI-driven efficiencies and innovations, they could see substantial improvements in productivity and competitiveness, leading to enhanced market performance.
For investors, the current environment offers strategic opportunities. Allocating a portion of a portfolio to high-quality small- and mid-cap stocks or through a broad-based index ETF can provide diversification benefits and potential for superior long-term returns.
Conclusion
The era of mega-cap dominance in the US financial markets is facing significant challenges. With slowing earnings growth, shifting investor preferences, and a more challenging economic environment, the mega-caps’ grip on market leadership may be loosening. As investors increasingly look towards small and mid-cap stocks for growth and diversification, the landscape of the US financial markets could be poised for a transition. Whether this marks the end of mega-cap dominance or merely a temporary shift remains to be seen, but the current trends suggest a more balanced market ahead.
For enquiries contact Michael Willms at mwillms@themilwaukeecompany.com