- Large-cap indices are at "all-time highs", but the average stock is down YTD.
- In general, the larger the market cap, the stronger the YTD return.
- Massive defensive rotation out of illiquid small-caps and into more liquid large-caps.
"Dow, S&P 500 close at new record highs" - Every Major Financial Publication, June 2, 2014
You wouldn't know it after reading any major financial publication yesterday, but the average U.S. stock is down over -1% thus far in 2014. But how can that be, if we're being told almost daily that the Dow (NYSEARCA:DIA) and S&P 500 (NYSEARCA:SPY) are hitting new all-time highs? The answer is likely to surprise you, especially if you have been focused solely on the large-cap space.
There is a massive divergence going on between the haves and have-nots, or the largest capitalization stocks and the rest of the equity market. As the table below indicates, the 50 largest stocks in the iShares Russell 3000 ETF (NYSEARCA:IWV) are up 4.1% in 2014, while the average return for the rest of the index (51-3000) is -1.1%. Since the small cap index (NYSEARCA:IWM) peaked back on March 4, the divergence has been starker, with the 50 largest stocks up 3.8%, while the rest of the index is down -4.9%.
There has been a nearly perfect relationship in 2014 between the size of a company and its return. The chart below speaks for itself, but I'll make one comment on it anyway. The largest 500 stocks are up +2.7% since March 4, while the smallest 500 stocks are down -14.7%. That is a truly incredible spread.
Market historians will recall the term "Nifty 50" originated in the 1960s bull market to describe 50 wildly popular large-cap stocks at the time. Interestingly, some of the same names from that list are leading the market higher today. The table below shows the Russell 3000 stocks with a market cap greater than $50 billion and returns greater than 5% year-to-date. The highlighted names were in the original Nifty 50, including Johnson & Johnson (NYSE:JNJ), Merck (NYSE:MRK), Walt Disney (NYSE:DIS), Schlumberger (NYSE:SLB), and PepsiCo (NYSE:PEP), among others.
The question for investors, of course, is what this selective advance means for the markets going forward. Is it merely a benign rotation into cheaper mega caps, or a harbinger of more difficult times ahead? Many seem to be arguing the former, using the fact that the major indices are still hitting new all-time highs, and the trend is still up to make their case. Indeed, extreme bullish sentiment here confirms that most investors don't seem to be bothered by the fact that the average stock has not been participating this year.
While it is hard to argue with these bullish investors (who could argue with "all-time highs"?), it is also hard to simply ignore the message that this selective advance is sending. In my view, that message is clear. The larger, institutional players are systematically rotating out of illiquid small caps names and hiding in names with the highest liquidity. They are, at the very least, anticipating a more difficult market environment to come, and likely something more severe. This defensive rotation is not simply from small to large, but can also be seen across sectors (Utilities are the top performers in 2014, Consumer Discretionary bottom performers) and asset classes (Long-duration Treasuries outperforming stocks and intermediate-term Treasuries). While the S&P 500 has ignored this defensive rotation thus far in 2014, the average stock has not.
Some food for thought the next time you read a headline about "all-time highs."
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