US equity leadership may change in the next business cycle

The large cap areas of the US market performed very well during the long phase of anemic growth, marginal inflation and low interest rates following the end of the Global Financial Crisis in 2009. As a result, the S&P 500 has become more concentrated in growth sectors like IT than at any other time since February 2000, which was just prior to the bursting of the Technology, Media and Telecoms (TMT) bubble the next month. Meanwhile, the US universe of small and mid cap companies has remained well diversified. Once again, the market is questioning big tech valuations.

In fact, the high concentration of large technology companies today is similar to the extremes we witnessed during the TMT bubble in contrast to the weightings among small cap stocks (Figure 1).

Figure 1:

After the TMT bubble burst in 2000, US small and mid cap companies performed much better than larger companies for a number of years up until 2007 (Figure 2). Such outperformance by small and mid cap companies occurred in years when the Fed Funds rate and GDP fluctuated. The consistent outperformance of small and mid cap stocks during a period of changing economic environments transpired partly because of the depressed starting point of valuations; additionally, robust earnings growth supported strong results. There are enough similarities between the 2000-2007 period and today to promote using this historical span as a comparison. In particular, the concentration of large caps in secular growth companies trading on high valuations appears to be on repeat.

Figure 2:

Small and mid caps are already outperforming large caps

Again we see signs that a new cycle of small and mid cap leadership may have already begun (Figure 3). US small and mid caps have been outperforming large caps since the end of January 2022. This is unusual in a period of recessionary fears but the dynamic partially reflects the starting point of much cheaper valuations of small and mid cap stocks. We believe the more domestic bias of small and mid cap companies will be much more of an advantage in the years ahead as factors such as deglobalization, i.e., the nearshoring of supply chains, and US fiscal incentives to increase domestic manufacturing start to have an impact.

Figure 3: