Ready for today’s investment pop quiz? Which is a healthier stock market: One in which the strongest performances are being produced by the small- and mid-cap sectors, or one in which the largest-cap stocks are leading the market?
This is an urgent question, since the largest stocks are now ahead of the small-caps for trailing five-year return -- as you can see from the accompanying chart. If that is a sign of ill health, as some believe, then the market is skating on thin ice.
(Specifically, the chart plots the ratio of trailing five-year returns of the cap-weighted version of the S&P 500 and the equal-weight version of that index. Because the cap-weighted version is dominated by the largest stocks, it will outperform the equal-weight version when the large-cap sector is leading -- and vice versa.)
The notion that a healthy market is one in which the smaller stocks are the leaders has both an anecdotal and a statistical basis. The anecdotal basis traces to sayings such as “if the troops will lead, the generals will follow,” which used to be widely quoted on Wall Street, especially during the “Nifty Fifty” era of the late 1960s and early 1970s. The reference to the “generals” was to the biggest of blue-chip stocks such as General Electric GE and General Motors GM, which at the time were among the largest-cap stocks in the market.
There also is statistical support for this notion. There has been a distinct tendency since 1970 for the stock market to perform better whenever the small-caps are beating the large-caps over the trailing five-years (as summarized in the table below):
|Annualized return over subsequent 5 years|
Whenever small-caps are ahead of large-caps for trailing 5-year return
Whenever small-caps are behind the large-caps for trailing 5-year return
So, unless the world has fundamentally changed, it is a source of concern that just recently the large-cap stocks pulled ahead of the smaller-cap stocks for trailing 5-year return. In fact, as you can see in the accompanying chart, the recent rise of this ratio above 1 is the first time it has done so since the go-go years of the late 1990s. We all know what happened after that prior occasion.
Another worrisome data point: The current reading is higher than 93% of all comparable monthly readings since the 1970s.
But has the world fundamentally changed? One researcher who argues that it has is Geoffrey Parker, a professor of engineering at Dartmouth College, who says we have moved into what he calls a “winner-take-all” economy. The reason for this is the so-called “network effects” of an Internet-dominated economy, which inexorably lead to the emergence of one dominant player in any given industry.
One very revealing data point that supports Parker’s argument comes from research conducted by Kathleen Kahle of the University of Arizona and Rene Stulz of Ohio State. The two professors measured the proportion of the total income of U.S. publicly-traded corporations that comes from the top 100 firms. This proportion held largely steady from 1975 to 1995, growing only slightly from 48.5% to 52.8%. But over the subsequent 20 years, to 2015, this proportion skyrocketed to 84.2%.
We’re always told that “this time is different” are the four most dangerous words on Wall Street. But this time it just may be. And, if so, recent large-cap strength is not the cause for concern that it otherwise would be.