Booming Stock Market Raises Doubts That Smaller Shares Discredit

Time to Take Advantage of Rich U.S. Stock Valuations?
  • Mid-caps beat S&P 500 by near record streak, up 12% this year
  • Equal-weight large-cap benchmark measure has advanced 9%

Animal spirits are alive and kicking in a surprising corner of the American stock market.

Sure, you can view 2016 as the triumph of defensive industries, or a hunt for yield, or the year when low volatility ruled. But those hoping to use these trends as the basis for a bear case on the U.S. economy should be aware that a group of stocks that normally benefits from domestic growth -- smaller ones -- is also having a banner year.

The best example may be the S&P Midcap 400 Index, which is up 12 percent this year, beating the S&P 500 Index by the most since 2010. The gauge, whose constituents do everything from build supermarket scales in Ohio to sell milk in Colorado, has topped the large-cap gauge every month since January, a streak that trails only the eight-month run in 1992.

While analysts are quick to note the shaky connotations of gains in utilities and phone companies, a different portent can be gleaned from the mid-cap stocks’ strength. It’s a reason for reassurance after a report Friday showed gross domestic product expanded at a 1.2 percent rate in the second quarter, less than half what economists forecast.

“It’s a broad stroke, but smaller companies tend to have more U.S. exposure,” said Mark Spellman, a fund manager who helps oversee more than $4 billion at Alpine Funds in Purchase, New York. His dividend-focused fund favors financial and health-care shares over utilities and telecoms. “When small and mid-cap stocks are doing well, a big part has to do with the comfort level that the U.S. economy is in good shape.”

Widening Breadth

Among other benefits, strength in smaller companies enhances breadth, a signature characteristic of the bull market’s best full years, 2012 and 2013, when practically everything went up. Gains narrowed last year as a reversal in earnings growth and concern about Federal Reserve interest rate increases drew a brighter line between winners and losers.

U.S. stocks fell on the first day in August, with the S&P 500 losing 0.1 percent at 10 a.m. in New York after five straight monthly gains sent the the index to all-time highs. Gains this year have been led by industries whose fortunes are least tied to the economic cycle, power generators and telecom providers. They’ve climbed at least 20 percent in 2016, almost twice as much as anything else, and retained their leadership even as data strengthened from hiring to manufacturing and real estate.

But the rally in defensive stocks is happening at the same time smaller firms are shining, something that has preceded faster growth in the economy.

Smaller Wins

Breaking down market returns by company size shows performance improves as stocks get smaller. Within the S&P 500, the 50 firms at the bottom decile of market capitalization rank the highest in returns, climbing an average 19 percent this year. An equal-weighted version of the benchmark gauge, one that strips out market value biases and gives Apple Inc. the same influence as Pitney Bowes Inc., is up 9 percent, beating its traditional version by 2.7 percentage points. That’s the biggest gap in three years.

In the mid-cap index, U.S. Steel Corp., Consol Energy Inc. and computer-chip maker Advanced Micro Devices Inc. led the advance, rising at least 130 percent.

“People are heavily crowded into these safe stocks because they are looking backward and go, ‘Things were really bad,’” said Andrew Slimmon, Chicago-based fund manager who oversees $5 billion at Morgan Stanley Investment Management. “My belief is the economy is accelerating and I’m getting validation in small caps and market breadth.”

MegaCap Trails

With heavyweights such as Apple and Google’s parent Alphabet Inc. trailing, the average stock is poised to surpass the cap-weighted S&P 500 for a third quarter. Stretches like that or longer have occurred nine times since 1989. On average, GDP accelerated a year later, with the rate of expansion picking up by 0.1 percentage point, Bloomberg data show. In contrast, when breadth narrowed, growth slowed afterward.

The broadening in gains is a departure from the previous year, where a handful of megacap stocks kept the market from collapsing. Past high-flyers, namely the FANG group of Facebook Inc., Amazon.com Inc., Netflix Inc. and Google, are up only 2.9 percent after surging 71 percent in 2015. They’re lagging behind the market for the first time since Facebook went public four years ago.

Even with all the breadth, high dividend and low-volatility stocks have been big contributors to the advance, underscoring investor worries over everything from Federal Reserve tightening to profit recessions to elevated valuations, according to Daniel Genter, who oversees about $4.1 billion as chief executive officer at RNC Genter Capital Management, in Los Angeles.

Worry List

The Fed last week said near-term risks to the economic outlook have diminished, taking a step toward raising interest rates later this year. Profits from S&P 500 companies are mired in a five-quarter decline as the slowest recovery since World War II is further squeezed by falling commodity prices and a strengthening dollar. At 18.5 times forecast profit, the benchmark gauge is traded at its highest multiple in more than a decade.

“People may still be concerned and they want to make sure that any new money they’re putting into the market is going to be highly diversified and not too speculative,” said Genter. “When you’re dealing with the undeniable fact that you’re in a slow growth environment and it doesn’t take that much, even if we are not seeing anything, to derail it, the defensive nature is going to be there.”

To Stephen Wood, chief market strategist for North America at Russell Investments, the rally in dividend stocks isn’t a rejection of the U.S. economy’s growth potential, but a response to the global central-bank stimulus that has driven bond yields to below zero from Japan to Europe.

Moreover, the biggest dividend payers share a characteristic with smaller companies -- dependence on demand at home. Utility and phone industries derive more than 90 percent of their sales from the U.S. while domestic revenue accounts for about 80 percent of the total for small and mid-cap companies, company filings compiled by Bloomberg and S&P Dow Jones Indices show. That compared with 56 percent for the S&P 500.

“The signal is healthy,” said Wood, who helps manage $244 billion at Russell Investments in New York. “The economic picture has been remarkably stable and that’s likely to continue.”

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