The Silver Lining for Smaller Stocks

In retrospect, it wasn’t surprising that risk-taking returned to the market in the second quarter, just a few months after a series of bank failures in March seemed to scare investors straight. Denial is a natural phase in the investment cycle, coming after delusion but preceding capitulation and despair. 

Yet denying that a problem exists doesn’t actually make it go away. The truth is, there are real problems this market must contend with, including the Federal Reserve’s still-restrictive monetary policy; 5.5% yields on 6-month T-bills that are tough competition for equities; the slowing economy; political instability in Russia; and a rally that’s been driven by a frenzy over artificial intelligence-related stocks and multiple expansion.

These things won’t disappear overnight even if the Federal Reserve is done raising rates, which remains a big if. Many of the effects of higher borrowing costs are already taking their toll, and there is a strong likelihood of further credit stress in the coming months. Banks have already increased their lending standards while cutting back on loan issuance, which amounts to a form of tightening indirectly caused by the Federal Reserve. 

Something else that cannot be denied is how narrow the breadth is in today’s market. So far this year, a smaller percentage of stocks are beating the benchmark than was the case in the run up to the global financial crisis, the dotcom crash, and the early ’80s recessions.

What’s more, the five biggest names in the S&P 500® account for nearly a quarter of the benchmark, though that figure has historically stood at around 13%. Narrow markets have historically been associated with poor performance while wide breadth has correlated with strong price gains in the 12 months after the fact. This is why one of Robert Farrell’s famous rules for investing is that the “markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.” 

The good news is, there is a corollary to this rule — one that signals hope for patient, value-minded investors like us who have a focus on small-cap names. Ned Davis Research examined past periods in which the market’s breadth narrowed—specifically, when fewer than 30% of the stocks in the S&P 500® were beating the benchmark. It found that in the 12 months following those instances, small stocks outperformed large stocks every time.