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Worried about market concentration and excessive valuations? Consider small caps

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If you’re worried about investing in large-cap stocks because of market concentration and high valuations, you may find comfort in allocating to small-cap stocks. Beyond concentration and valuation considerations, there are a few other reasons why now is a good time to add small-cap stocks to your portfolio.

As the U.S. stock market hit an all-time high in June, large-cap concentration has also approached levels not seen since the tech bubble. As of May 31, the top 10% of stocks accounted for about 66% of the market capitalization of the Russell 1000 Index. Stock market valuations for the Russell 1000 Index, which represents the 1,000 largest U.S. companies by market capitalization, also appear to be rising. The index’s price-to-earnings ratio (PE) was 25.6 in May, putting it in the 92nd percentile since inception.

Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data runs from January 1980 to May 2024. Equity concentration is the percentage of market capitalization held by the top 10% of companies in the Russell 1000 index.

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More attractive fundamentals

After decades of technological advances, technology sectors such as information technology and communication services now account for more than 38% of the total Russell 1000 Index. Valuations of mega-cap companies in these sectors have risen, driven by high growth expectations. In contrast, the distribution of sector weights and PE ratios of constituents of the Russell 2000 Index (2,000 small-cap companies) is more moderate and standardized, as shown in Figure 2.

Market concentration concerns 2

Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. As of 31 May 2024.

Small caps are trading at a significant discount to their larger caps compared to their historical peers. Figure 3 shows the forward PE ratios of the Russell 2000 and Russell 1000 since 1990. As of May 31, the forward PE ratio of small caps to large caps was 73%, meaning that small caps are currently trading at a 27% discount to their larger caps. This low discount ranks them 18th in the world.Number Percentiles for the past 35 years.

Market concentration concerns 3

Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data from March 1990 to May 2024. Stocks with negative earnings are excluded.

Small-cap to large-cap valuation ratios have predictive power for future relative performance. In Figure 4, we created a scatter plot of forward PE ratios and 10-year forward return spreads for small and large caps. The trend line has a slope of -0.11. The negative slope, or beta coefficient, indicates that cheaper relative valuations are likely to lead to better performance for small caps. Relative valuations explain 60% of the total variance in 10-year forward return spreads. Given current historically low valuations, we expect small caps to outperform large caps over the next decade.

Market concentration concerns-4

Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data from March 1990 to May 2024. Forward PE does not include stocks with negative earnings.

Small caps perform well as economy recovers

Small-cap companies are younger and less established than their large-cap peers. Small-cap companies are more sensitive to economic conditions and therefore more correlated with business cycles. As the economy recovers and begins to expand, small-cap stocks tend to rebound the most due to their more attractive valuations. Exhibits 5a and 5b show the average returns of small-cap and large-cap stocks over different business cycles. Small-cap stocks outperformed large-cap stocks by an average of 66 basis points (bps) and 493 bps during recovery and expansion periods, respectively.

Market concentration concerns - 5a
Market concentration concerns - 5b

Sources (5a and 5b): FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. Data runs from January 1984 to April 2024. Performance in Figure 5b is the annualized average monthly returns for Small (Russell 2K) and Large (Russell 1K).

Our macroeconomic regime model suggests we are currently in a recovery regime as month-over-month changes in leading economic indicators remain negative but trending upwards. Small caps will outperform large caps when the economy is on track to a full recovery and beyond.

Interest rates could be a tailwind for small-cap stocks

Small businesses are less well-off than larger businesses in accessing external debt financing and rely heavily on floating rate, short-term borrowings to fund their operations. When the Federal Reserve raises interest rates and tightens monetary policy, small businesses face a significant increase in their cost of capital, which can negatively impact profitability. However, when the Fed begins to lower interest rates and ease monetary conditions, small businesses stand to benefit more than larger businesses from improved credit conditions.

Figure 6 shows the interest rate sensitivity of small vs. large stock return spreads to changes in the federal funds rate. The y-axis of the scatter plot is the one-year forward return spread between the Russell 2000 and the Russell 1000. The x-axis shows the quarterly change in the effective federal funds rate. The negative regression beta indicates that lower interest rates have historically improved the future performance of small stocks. The forward-based relationship is also statistically significant with a t-statistic of -3.1. This analysis provides empirical support that expected Fed interest rate cuts are likely to be a tailwind for small stocks.

Market concentration concerns-6

Source: Bloomberg, NTAM Global Asset Allocation Quantitative Survey. Quarterly data from January 1984 to May 2024.

Small businesses could benefit from reshoring

According to the International Monetary Fund According to the research report, globalization has entered a new phase of “slowbalization.” With the World Trade Openness Index plateauing due to rising geopolitical tensions, many large multinational companies have begun to shift their supply chains back to domestic suppliers, which is likely to benefit mid-sized companies that tend to be more domestically oriented than large companies.

Market concentration concerns-7

Source: FactSet, Bloomberg, NTAM Global Asset Allocation Quantitative Research. As of 17 June 2024.

Key Takeaways

Investors have grown increasingly concerned about large-cap stocks due to high market concentration and inflated valuations, while small-cap stocks appear to be overbought despite attractive fundamentals.

Current economic conditions are favorable for a recovery in small caps, and reshoring should benefit small U.S. companies in the long term. All of these factors combine to make a compelling case for allocating a portion of your assets to small caps.

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