Bigger is Better… Or is it?

Last quarter we discussed the divergent performances between the US stock market, emerging markets and other developed markets. In particular, we noted how the gap between the US and emerging markets is now at its widest since 1988, per the below graph. Importantly, we also noted how this gap has inverted several times in the past, suggesting the possibility that it may do so again.

This quarter we’re going to build on this and consider a second source of divergent performance, even within the US: Market capitalization, or company size. The biggest corporations in America have outperformed the rest. Consider the following graph comparing the performance of the S&P 500 (500 biggest companies in America – megacaps) and the Russel 2000 (a broader index of corporate America, excluding the 1000 biggest companies – midcaps).

While the divergence isn’t as extreme in this instance, it is nevertheless notable since a) these two indices generally track one another quite closely, and b) there appears to be a correlation between megacaps outperforming midcaps, and the US outperforming the rest of the world: We saw the same phenomenon between 1998 and 2003 during the Tech Bubble.

Both the relative performance figures and the prevailing narratives of the last decade would suggest that US Megacaps are the only game in town. Bigger is better, everything else is a waste of time. But is this true? Should we simply abandon everything else and pile into the S&P 500? Afterall, that’s what’s worked for the last decade. The above graphs suggest that caution is warranted – we’ve seen this trend reverse in the past. Might it happen again, or is this time different?

What’s been driving US Megacap performance?

To understand whether this time is likely to be different, we need to understand what drives return over different time periods. Total return can be expressed as the sum its constituents as follows:

Importantly, these constituents can be grouped together into either sustainable drivers of return, or non-sustainable drivers of return. Sustainable drivers of return are those which are expected to persist and compound over time. These would include dividend yield and revenue growth. Non-sustainable drivers of return are those which do not persist over time. They tend to fluctuate rather than compound. These include change in profit margin, revaluation and currency fluctuation.

Over very long periods of time (20+ years), total return tends towards sustainable return. Over very short periods of time however, total return tends to be dominated by fluctuations in the non-sustainable drivers of return. For example: Over the last 20 years, sustainable return has accounted for 70%-85% of total return on most stock markets. Over the last year though, non-sustainable return has accounted for between 80% and 120% of total return in those same markets. This is exactly what we’d expect to see.

Why is this important? Because over the last 10 years during which US Megacaps have outperformed everything else, that outperformance has been driven almost exclusively by non-sustainable drivers of return. US Midcaps have actually done slightly better in terms of underlying sustainable return. This observation is consistent with our analysis from last quarter – that the S&P 500 is very overvalued relative to everything else.

While we cannot predict the future, we can look at what happened the last time this scenario played out by examining the decade which followed from 2000 to 2010 (see the graph below): Even though US Megacaps delivered a fair sustainable return in that decade, it was outweighed by negative non-sustainable return, resulting in a negative total return (the black dash represents total return). Emerging markets won the race that time. This doesn’t mean the future will play out exactly the same. History doesn’t always repeat itself, but it does rhyme and we’d do well to learn from the past.

Is this a Bubble?

The last time we saw a divergence of this magnitude was during the Tech Bubble in 2000. This begs the question: Are we seeing a similar bubble in US Megacaps today? And if so, what is it? There has certainly been a lot of hype in the AI space, particularly with Nvidia, but this is a fairly recent development and doesn’t fully explain the phenomenon we’ve observed in recent years. There is another more subtle force at play which may better explain what we’ve been observing in the last few years: The rise of ETFs and other index trackers. Index trackers now account for more than half of assets under management in the US, up from 20% in 2009. By far the most tracked index in the world is the S&P 500. Could this supply/demand dynamic be driving the relative outperformance of the S&P 500 vs everything else? The fact that almost half of the total return of the S&P 500 over the last decade has come from non-sustainable return drivers lends support to this idea. We’ll likely discuss this in more detail next quarter and consider some of the hidden risks this trend has introduced to financial markets.

What does all this mean for us practically? We’ve positioned our portfolios to take advantage of a normalization in the trend between US Megacaps and the rest of the global stock market. As uncomfortable as it is to sit on the sidelines of this US Megacap boom, the only thing less comfortable for us is to take the risk associated with jumping on the bandwagon. A globally diversified portfolio of high-quality businesses trading at attractive valuations is more likely to deliver good long-term returns than the current hype, as it has in past cycles. It also carries far less risk of the bottom falling out. But it does require patience and discipline. As Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.”