Is the tide turning on US stocks?

The writer is an FT contributing editor

The rise and rise of the S&P 500 has accompanied exceptional US economic growth. It’s tempting to see it as an expression of that.

But is the tide turning? Index price falls over recent days may turn out to be just a minor correction. But under the bonnet, the rest of the market has looked less stellar for some time.

In the first half of 2024 the largest 20 US-listed stocks delivered a 27 per cent gain and accounted for three-quarters of the total US market return of 15.3 per cent, according to JPMorgan.

Meanwhile, an equally weighted version of the S&P 500 index underperformed the stock markets of every other major region in the world. In the second quarter it lost money. Small caps, with a more domestic focus, have had an even worse time of it — although last week they partially snapped back to record their strongest five-day outperformance of large caps stocks in at least four decades, according to Goldman Sachs.

Still, behaviour over the past few years has been unusual. Over the long term, the S&P 500 equally weighted index — where every stock accounts for the same percentage of the benchmark — has tended to both fluctuate with, and outperform, the main index where companies are represented in line their market capitalisation. There have been only nine quarters when holding an equally weighted basket of stocks has lost you money in a rising market since 1990. Two of these have been in the past three years, over which period the equal-weighted market has lagged behind by more than five percentage points per annum.

And in the context of exceptional national economic growth, this should be surprising. Nominal GDP growth of close to 8 per cent per annum over the past three years provided a significant revenue tailwind, and the sort of environment in which you’d expect healthy profit growth. Sales growth across larger companies has more than kept pace. But smaller business revenues have lagged behind. And, overall, smaller company earnings have fallen sharply over the past 18 months leaving them lower than they were three years ago.

What accounts for these developments? Looking backwards, higher interest rates help explain the softening fundamentals. Debt-free, cash-rich tech titans feel the pinch of higher rates only when their customers are in enough pain to slow their orders. More labour-intensive companies carrying debt — which equal-weighted indices better represent — get squeezed not only by higher input costs but also by the policy remedy to them. Monetary policy works by hurting.

Weakening fundamentals across indebted businesses should show up in corporate bond markets. But credit spreads have continued to narrow across almost all broad tranches of credit quality. This is despite the Federal Reserve’s Senior Officer Loan Survey reporting tighter standards, weaker demand and higher risk premia on new loans to firms — developments that would typically be accompanied by credit market distress. To square the circle, we need to see that management of more indebted companies have been paying down debt where they can, another manifestation of monetary policy working. Where debt reduction has been impossible, as in the riskiest corner of the US high yield market, spreads of CCC-rated firms have widened and the default rate has increased, although expectations from here are mixed.

Looking forward, softer inflation prints bring hope of monetary policy relief. June’s softer US inflation numbers stoked expectations of a swifter path to rate cuts, boosting bond prices and the stocks of smaller companies. 

But the upcoming US presidential and congressional elections leave questions hanging over the market. Goldman Sachs’ global chief economist Jan Hatzius, presenting to a gathering of European Central Bank policymakers in Sintra, analysed the economic impacts of a combination of large tariffs and tax cuts promised by Donald Trump’s campaign. His conclusion was that they would deliver a weaker economy, higher inflation and a stronger US dollar. Such stuff is not usually good news for stocks.

David Lebovitz, a global markets strategist at JPMorgan Asset Management, argues that it is hard to see a fundamental driver for any extended performance of smaller US companies. A second Trump administration that led to rates being held higher for longer would more than offset the benefits of protection to domestic-facing companies afforded by tariffs. However, he sees a decent outlook for large-cap businesses in the financial, industrial and energy sectors as they exit their mini-earnings recessions.

The largest megacap companies have been forging their own path. Their sheer size in capitalisation-weighted stock indices has taken overall market returns with them. Index-based investors may not care where returns have come from. But concentrated gains among a handful of leaders have been hiding broader market softness. While US economic growth has looked exceptional, the same can no longer be said of most US stocks.