The Small-Cap Stock Resurgence

Recently, a seismic shift has occurred in the stock market. Once overshadowed by their larger counterparts, small-cap stocks have dramatically outperformed the market. This unexpected turn of events has caught many investors off guard. It's a stark reminder that market trends can change rapidly, and that chasing performance and only investing in the hot trends can have detrimental effects on your portfolio.

The Concentration of Market Returns

The substantial market capitalizations and robust growth prospects of industry giants like Apple, Microsoft, and Amazon, led to a skewed distribution of returns, with only a few stocks delivering outsized gains while others lagged behind.

This phenomenon of market concentration was driven by several factors, including technological advancements, consumer behavior shifts, and macroeconomic trends favoring large, established firms. For instance, during periods of economic uncertainty, large-cap stocks are often perceived as safer investments due to their financial stability and established market presence.

For the three-year period ending June 2024, the Russell 1000 Growth Index (an index comprised of U.S. large-cap growth-oriented companies) returned +37%, whereas the Russell 2000 Index (an index comprised of U.S. small-cap companies) returned -8% over the same period. That is a 45-percentage-point difference in return!

Ongoing underperformance has led many small-cap stock investors to throw in the towel and over-allocate to large-cap stocks in hopes of capturing more of these returns.

The Recent Reversal: Small-Cap Stocks Outperform

Recently, however, we've witnessed a significant shift in market dynamics. U.S. small-cap stocks have begun to outperform large-cap stocks by a wide margin. From July 9th through July 26th, the small-cap index increased +12% vs. a -7% decline in large growth stocks, a 19-percentage-point difference. While this hasn't completely eliminated the long-term performance gap, it helped reduce it.

This reversal can possibly be attributed to several factors, all of which are important when considering your long-term investment portfolio:

1. Economic Cycles: Small-cap stocks tend to perform well during periods of economic expansion. Recent economic data continues to show an expanding economy, and smaller companies, which have been dragged down by longstanding fears of a looming recession, have started to rebound.
   
   
2. Valuation Rebalancing: After years of large-cap stocks leading the market, their stock price valuations became relatively high compared to small-cap stocks. As market dynamics shift, small-cap stocks, which may have been undervalued, are potentially starting to provide substantial growth opportunities.
   
   
3. Potentially Lower Future Interest Rates: The Fed's increasing interest rate has disproportionately hit small-cap stocks. With the expectation that the Fed may soon begin reducing interest rates, these lower borrowing costs can benefit smaller companies more.
   
   

The Perils of Chasing Performance and the Importance of Diversification

The allure of high returns can be irresistible. Investors often find themselves tempted to chase performance by shifting their portfolios to align with the latest hot trend. However, history has shown that this strategy can be perilous. By the time a trend becomes widely recognized, it's often nearing its end. Market timing is notoriously difficult, and those who attempt to predict the next big thing often find themselves on the wrong side of the market.

The recent market upheaval underscores the critical role of diversification in investment portfolios. By maintaining an allocation to investments that is spread out across various asset classes, sectors, and company sizes, investors can mitigate the impact of any single asset's performance. A diversified portfolio is designed to weather market storms and provide a smoother ride over the long term.

Summary

The market is a dynamic environment where trends can shift unexpectedly. The recent outperformance of small-cap stocks is a powerful reminder that past performance does not indicate future results.

Investors who prioritize diversification and maintain a long-term perspective are better equipped to navigate the ever-changing market landscape. While there's no guaranteed path to investment success, a well-disciplined approach not only helps manage risks but also capitalizes on opportunities across different market conditions, ultimately leading to more sustainable and rewarding investment outcomes.