Will Nasgovitz 2023-12-24 22:12:42
The legendary investment strategist Bob Farrell famously noted that “markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.” By this standard, the outlook for 2024 may be challenging.
So why, then, are we optimistic?
There’s no denying that the breadth of this market is as narrow as it’s been in recent memory. Just seven stocks—the socalled Magnificent 7, made up of Apple, Alphabet, Tesla, Amazon, Microsoft, Meta and Nvidia— accounted for virtually all of the equity market’s gains in 2023. Thanks to the dominance of those mega caps, the market-cap-weighted S&P 500® index was up more than 9% in 2023 (through Oct. 31) while the equal-weight version of that same benchmark is down 4%.
The market’s sparse leadership has now reached historic proportions. For much of last year, a smaller percentage of stocks were beating the broad market than in recent instances of narrow breadth, which coincided with volatile markets. This includes the run up to the global financial crisis, the dotcom crash, and the early ’80s recessions (see chart).
While narrow markets have historically been associated with poor performance, there’s a corollary to this rule, one that signals hope for patient, value-minded investors who focus on small-cap names.
In past instances of extremely narrow leadership—when fewer than 30% of stocks in the S&P 500® were beating the benchmark, as is the case today—small stocks always outperformed large caps in the 12 months that followed, according to Ned Davis Research. Sometimes, those periods of outperformance extend for longer. After the dotcom bubble burst in March 2000, for instance, small stocks went on to outperform large caps for the next seven years, gaining more than 60% while large caps returned less than 7%.
Of course, fueling the small-cap rally back then were historically low valuations on small-caps, both in absolute terms and relative to large stocks. Today, the price/earnings ratio for the S&P 600 Index of small stocks, based on projected earnings over the next 12 months, is even lower than it was in 2000.
This is why small-cap investors—who’ve been frustrated by the dominance of mega-cap stocks lately, driven in part to the mania surrounding artificial intelligence—need to focus on opportunities on the other side of this market. If history is a guide, breadth eventually broadens out, and small-cap stocks are likely to be the beneficiaries of this transition.
It’s also why we believe the outlook for value-minded small cap investors who are patient and disciplined is both constructive and hopeful.
William Nasgovitz is CEO and Portfolio Manager of Heartland Advisors.
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