Anthony Saglimbene, Chief Market Strategist – Ameriprise Financial
Justin Burgin, Vice President of Equity Research – Ameriprise Financial
Sept. 18, 2023
The companies with the highest market capitalizations, including many tech stocks, continue to drive most of the S&P 500 Index returns this year, widening the performance gap between large-cap and small-cap stocks.
Here’s what’s driving this outperformance among the large-cap stocks, and our view on whether the trend will continue through the end of the year:
AI fuels a rise in large-cap valuations
Investor enthusiasm for artificial intelligence (AI) turned several large-cap technology companies into even larger-cap technology stocks over the course of 2023. In fact, eight of the 10 largest companies in the S&P 500 Index by market capitalization (the number of shares outstanding multiplied by stock price) are considered beneficiaries of the longer-term AI growth story.
Data through the end of August shows the dramatic impact these top 10 companies have had on overall stock market performance. Specifically, the S&P 500 Index (which is a market-capitalization weighted index) generated a total return of +18.7% from the start of 2023. However, excluding the 10 largest stocks, the return calculation drops to just +4.2%.
Higher stock prices typically yield higher valuations as investors try to estimate the impact of future growth potential. And with much of the growth potential for AI expected in future years, the price-to-earnings (P/E) multiples for the largest companies in the S&P 500 Index have moved higher.
In the chart below, we expanded the universe to include the top 50 companies in the S&P 500 Index to help show the dramatic rise in valuation metrics. As shown, the largest 50 companies in the S&P 500 have a median P/E of almost 31x. However, the remaining ~450 companies in the Index have a substantially lower P/E multiple of just under 22x. For reference, the 5-year median P/E for the S&P 500 is approximately 21x.
Median P/Es is calculated by excluding companies with negative earnings.
Data as of Aug. 31, 2023
Data sources: FactSet, American Enterprise Investment Services Inc.
These figures are shown for illustrative purposes only.
Interest rate uncertainty could weigh on the market
While the top 10 companies drove most of the S&P 500 Index returns in the first half of 2023, the market broadened out in July to include a wider set of sectors and stocks that had been left behind. For example, in July, energy, financials and U.S. small-cap stocks outperformed the S&P 500.
However, stock trends in August quickly turned less favorable as the backup in interest rates and subtly changing views on how much higher the Federal Reserve will need to raise the Fed funds target rate weighed on sentiment. Notably, a batch of stronger-than-expected economic data last month fueled the idea that good news on the economy may mean bad news for stocks. However, weaker-than-expected economic releases on the job front in late August and lower interest rates helped mitigate stock losses for the month.
That said, the outlooks on long-duration assets (such as stocks) dimmed slightly compared to earlier in the year. Simply, as rates remain elevated, the present value of a company’s future profits become less valuable when discounted back to the present. Unsurprisingly, areas of the market focused on growth (e.g., some of the largest 50 stocks in the S&P 500), technology and small-caps experienced outsized selling pressure in early August compared to value as well as the broader S&P 500. Valuations in these select areas are more closely tied to their profit “potential”; hence, their sensitivity to rates has led to increased stock volatility in the third quarter.
Historical headwinds in the fall will likely challenge all stocks in the short term
September is a historically weak month for stocks — it’s one of only two months in which the S&P 500 averages a negative return over the last 20 years. Further, the rolling four-week average of daily volatility in the S&P 500 tends to increase steadily through early November, according to Bespoke Investment Group.
This uptick in stock volatility in September and early October makes sense from a calendar perspective: Traders are through their summer vacations, the holidays are still out in the distance and the year starts to shorten quickly for professional money managers as targets and return performance for year-end bonuses approach.
As the chart below shows, broad market volatility in 2023 seems to follow the seasonal pattern of lows reached in the early summer, followed by rising volatility heading into September.
Data as of Aug. 31, 2023
Data sources: Bloomberg
These figures are shown for illustrative purposes only.
However, longer-term investors should take this information in stride. For all the ups and downs in the market over recent years, the S&P 500 is higher by over 18% YTD on a total return basis through the end of August, up nearly +1.5% over the last two years (that includes 2022’s 18% decline) and is higher by +10.5% annualized over the previous three years, according to Morningstar data. The ability to look through a bit of volatility, as well as the brief periods of downdrafts that occur in the market, tends to reward the patient investor.
Bottom line: Will large-cap outperformance continue?
With economic activity moderating and returning closer to longer-term averages this year, we believe investors will likely continue to seek out companies with strong secular drivers and outsized potential for profit growth. For example, while the top 50 stocks are expensive from a valuation perspective, these companies also tend to be the secular drivers of the U.S. economy. Thus, balancing a portfolio with a mix of growth and value stocks can help keep investors participating when high P/E equities are moving higher. It can also help mitigate risk when volatility arises or when value stocks attract more attention.
Position your portfolio for the long term
Regardless of how the broader market trends over the very near term, a slightly defensive but generally balanced portfolio continues to be a prudent approach. Reach out to your Ameriprise financial advisor if you have questions on how your portfolio is positioned.