Investment Climate July 2024: Mega-Cap Mirage

In the second quarter of 2024, the major stock market averages continued to reach new highs. However, the drive higher was primarily limited to the mega-capitalization companies with trillion dollar-plus market values, leading to a false sense that the stock market is experiencing a “bull market.” When only ten companies represent over 35% of the S&P 500, the price movement of those stocks can have an oversized influence on the market in way that masks the true health of the broader market.

In reality, the broader stock market has not fared as well in the past quarter. If you look at the Russell 2000 Index of small capitalization companies, you will find that this index has not performed anywhere near as well as the larger indexes. As of mid-2024, it has not made it past its old high that it established in 2021. We believe that the outsized performance from the largest of the large companies in the world is not a healthy sign for the overall market. We would not be surprised to see that the result is a correction of these mega-capitalization companies over the coming months, quarters, and even years that would then generate a negative general perception of market health.

The main culprit for the comparative underperformance of smaller companies has been the extension of “higher for longer” as it relates to the U.S. Federal Reserve policy on interest rates. Towards the end of 2023, it appeared inflation had been tamed and a small rotation to small and mid-sized companies had begun to take hold—only to be squelched as inflation proved stubborn in the first few months of 2024, reversing the rotation that was materializing. While it is misguided, the Fed believes economic growth can be inflationary, and thus the continued growth in the economy has also created a cloud of fear over stock market investors that higher for longer will go even longer than expected.  

Do not be misled by the reports of a growing economy, as most of the growth is coming from growth in government, which is another unhealthy sign. While government and the mega-capitalization companies suck up more capital, companies in the private sector—particularly small, innovative startups—are starved of the capital they need to grow. The dearth of new public companies is evidence of that problem. 

We have repeatedly referenced what we call the “8000 to 4000” problem, or the shrinkage in the number of public companies in the U.S., in our diagnoses of the state of the market. Unfortunately, the past quarter serves to demonstrate yet again that for us investors this is the major problem of our time. Over 87% of the companies in the U.S. that are generating over $100 million in revenue are private companies. This is a remarkable figure, and it suggests that the regulatory environment for public companies is simply too onerous for the vast majority of companies to embrace. The bright side is that there is a new opportunity evolving in private company investing that clearly has grown and will continue to grow.  Since most innovation, and employment, is generated by smaller companies, this is a very important phenomenon that every investor must come to grips with sooner or later.

Meanwhile, there are some extremely undervalued small and mid-sized public companies out of the over 4,000 companies that are still public. These companies cannot be ignored for long—even during a period of market correction. We believe we own over 40 of them and expect that they will once again shine in the coming months, quarters and years.