In a distant age, prudent equity portfolio risk management included broad diversification across sectors, geographies and market capitalizations. But in recent years, the concentration of a few large technology stocks has been well above historic averages. The top 6 stocks in the S&P 500 are all technology stocks and represent over 30% of the index. Because of this high concentration of large cap technology stocks, portfolio managers who embrace broad diversification have had a difficult time keeping pace with the returns of the S&P 500 index. But things may be changing.
On July 11, 2024, the market saw an unusually large divergence between various indices of the market. The S&P 500 declined 0.88% that day while the Russell 2000 index of small capitalization stocks rose by a whopping 3.57%. The divergence of 4.55% was the fourth largest one day outperformance since the crash of 1987. During the following 4 days, that outperformance nearly doubled and was just shy of the 5-day outperformance during the crash of 1987. Although the S&P 500 index was down less than 1% over that period, perhaps the markets are now signaling that we have reached an inflection point of large cap technology stock outperformance.
Having a career spanning a number of market cycles, I have consistently advised clients that the yawning gap between large cap technology stocks and the rest of the market seems unsustainable. A full reversion to the mean between the valuations of the large cap technology stocks and the rest of the stock market may seem unlikely due to the differentiated growth profiles. But even a modified reversion to the mean could be rapid and impactful.
I looked at the returns of the Russel 2000 in the year following those instances of 5 days of extreme outperformance over the S&P 500. With regard to 1987 (October 13 – October 19), the Russell continued to outperform modestly in the year following. In the 12 months following the third largest outperformance (March 19 – March 25, 2020), the Russell 2000 outperformed the S&P 500 by over 50%. I would like to suggest that one reason for the continued stronger outperformance in 2020 may be that broad stock market valuations in 1987 had much less dispersion from the mean. Perhaps the strong outperformance of the broader market in 2020 was partially due to a reversion to the mean rather than an aversion to large cap technology stocks. (In fact, large cap tech did perform better than the S&P 500 during that period).
Takeaways
I believe that the magnitude of the recent outperformance of the Russell 2000 over the S&P 500 carries some significance and should not be ignored by investors as some kind of anomaly. The implications of this occurrence are certainly subject to debate.
This outperformance could be a signal that the gap in valuation between the large capitalization technology stocks and the broader market may have reached an extreme. I should point out that the outperformance of the Russell over the tech-heavy Nasdaq 100 during the July 11 – July 16 period was a whopping 1240 basis points. There were 5 other 5-day periods when the Russel 2000 outperformed the Nasdaq 100 by double-digits percentage and 4 of those instances were in the year 2000, when the tech bubble was bursting.
To conclude, I would aver that the recent anomaly of large outperformance between the Russell 2000 over the S&P 500 and Nasdaq 100 should compel investors to perhaps reexamine their portfolio weightings to highly valued large capitalization technology stocks.
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