Dan Reiter, CFP®, CPA
The economic results in the second quarter have included a whipsaw of mixed signals between caution and confidence. One cause may include a growing separation between confidence levels for high income and wealthy households and those lower on the wealth spectrum. Spending on categories such as high luxury services continue to post strong results, while consumer goods are beginning to see softer numbers. In the May jobs report, for example, the leisure and hospitality sector alone added 42,000 jobs – almost double what the entire goods-producing sector of the economy created in the same month.
One possible explanation of such separation in the economy might be that excess savings from the pandemic stimulus are gone for the less wealthy, while savings balances remain high for those in the upper cohort. If you’re among those lucky enough to not have a mortgage on your home, for example, you’re likely feeling more confident with greater home equity as the median existing home value rose from $270,000 pre-pandemic to a record of $419,300 in May. On the other hand, those that are more debt reliant such as younger and lower-income households are bearing the lion share of stress related to higher interest rates as auto and credit card loan delinquencies have risen above pre-pandemic levels.
Most economists are viewing such factors with a close eye on inflation data as we look ahead to the third quarter. Notably, high consumer spending overall is reason for economic optimism, while a muted jobs report on July 5th provides support for reduced inflation ahead. As a result, the stock market has reacted positively with broad expectations of an economy that is cooling but not showing broad signals consistent with an impending recession. Consequently, many economists are growing more confident in the potential “soft landing” outcome where inflation is under control and the Federal Reserve is afforded the opportunity to reduce interest rates before a recession occurs.
Much as there has been a divergence between two economies, the second quarter presented a growing tale of two stock markets. The S&P 500 index, an index of the 500 largest domestic public companies by size, has grown approximately 17% this year. Conversely, the Russell 2000 Index, an index made up of 2,000 smaller domestic public companies, has grown only about 1%[1].
Two factors seem to explain much of this separation. First, the market has shown great enthusiasm for a small group of technology companies involved in the growing use of artificial intelligence. Second, several of the largest companies are insulated from high interest rates by large cash piles.
Does this mean that investors should make any changes to focus more attention on investing in only large technology companies? In short, no. Why? Risk and reward.
The S&P 500 index has become increasingly concentrated in only a handful of companies, the majority of which are in the technology industry. Currently, the largest ten companies (out of 500), make up 37% of the index’s value, but contribute only 24% of its profits. This is the largest such a value/earnings gap has been in over thirty years.
If an investor holds only funds focused on the largest 500 companies, they are becoming increasingly more exposed to the performance of only a handful of companies (and one industry). Less diversification in your investments may mean more risk to you as an investor.
More importantly, history shows that setting aside smaller and less expensive companies for their large growth-oriented cousins after similar periods of outperformance is a mistake. Large companies outperformed or performed similarly to “small value” companies over preceding twenty-year periods in 1947, 1965, and 1999. However, within three years of each of these observations the 20-year return difference reversed, and smaller value companies outperformed their large cap counterparts by more than three percentage points annualized[2].
The point? Many times in history specific areas of the stock market have gone through periods of high performance that the market thereafter shifted elsewhere quickly and enthusiastically. Investors should certainly hold many of the largest stocks that will continue to benefit from growth in technology. However, failing to diversify your portfolio to include those overlooked areas of the stock market may result in higher risk and opportunities left on the table.
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[1] Source: Yahoo Finance.
[2] Encouraging Data from Value’s Past and Present. Crill, Wes. Dimensional Fund Advisors.
