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Headlines
- Small-cap stocks outperformed large-cap stocks in July, with the S&P 600 Small Cap ETF climbing 10.8%.
- U.S. money supply growth and the valuation gap between small and large-cap stocks suggest continued strength for small caps.
- The S&P 600's profitability requirement makes it a more reliable index for tracking small-cap stocks.
The stock market experienced a mixed month in July. The S&P 500 initially surged, setting another all-time high, but began to falter mid-month, ultimately erasing all its gains for July at one point.
As investors shifted away from stocks in the S&P 500, it became evident where they were reallocating their funds. Small-cap stocks soared amid the S&P 500's decline, in what the media dubbed the great rotation. The SPDR Portfolio S&P 600 Small Cap ETF (SPSM) climbed 10.8% in July, while the SPDR S&P 500 ETF (SPY) finished the month just 1.2% higher. Several factors indicate that small caps may continue to outperform large-cap stocks for some time. Two significant market indicators suggest this might only be the beginning of the S&P 600 rally.
U.S. Money Supply is Growing Again
The U.S. money supply saw substantial growth in 2020 as the Federal Reserve lowered interest rates and the government issued stimulus checks to consumers. However, this growth began to slow in 2021, eventually leading to a year-over-year contraction in 2022.
This trend reversed earlier this year, with money supply growth turning positive. In April and May, the M2 money supply (which includes cash and easily accessible cash equivalents like CDs) increased by 0.6%. In June, the most recent reading showed a nearly 1% year-over-year increase. If the Federal Reserve lowers interest rates later this year, as anticipated, the growth rate should continue to accelerate.
This scenario is highly favorable for small and mid-cap stocks. Khuram Chaudhry, Head of European Quantitative Strategy at J.P. Morgan Securities (NYSE:JPM), notes that stock market concentration typically rises as money supply growth falls and vice versa. Thus, as the money supply increases, smaller companies gain more access to cash, reducing their cost of debt. Consequently, market concentration should decrease, leading to a shift from larger to smaller stocks.
The Valuation Gap Remains High
The valuation gap between the S&P 500 and S&P 600 reached its highest level since the early 2000s at the beginning of July. Despite some narrowing as small caps outperformed, the gap remains significant.
At the end of July, the forward P/E ratio of the S&P 500 was 20.6, compared to 15.4 for the S&P 600. Although this gap of 5.2 points is narrower than the 7.4-point gap seen in early July, it remains one of the highest levels since 2001. Historically, when this gap reaches such levels, small caps tend to outperform. For instance, from the end of 2001 to the end of 2011, the S&P 600 achieved a total return of 98%, compared to 33% for the S&P 500. The S&P 600 also outperformed the S&P 500 in 2022, leading to a reduction in the valuation gap.
Despite the recent strong performance of the S&P 600, there is still significant room for the valuation gap between small and large caps to normalize. Smaller companies typically grow faster than larger ones, theoretically supporting higher valuations. Indeed, from 2003 to 2018, the S&P 600 consistently had a higher forward P/E than the S&P 500. This dynamic highlights the intriguing landscape of financial stocks within the broader market.
Why the S&P 600?
The S&P 600 is not the most widely used index for tracking small-cap stocks; that title belongs to the Russell 2000. However, several high-profile investors have made substantial bets on Russell 2000 index funds ahead of the great rotation. The S&P 600, however, requires companies to demonstrate consistent profitability to be included in the index. This profitability requirement enhances the quality of companies in the index, making it more reliable. Consequently, the S&P 600 tends to lean more toward value stocks than growth stocks. Historically, small-cap growth stocks have been the worst-performing market segment, making the S&P 600 a more attractive choice over the Russell 2000.
There are various ways to interpret market indicators and trends. While no market indicator or analyst can predict the future with certainty, the indicators suggest that small-cap stocks still have significant potential for growth, and the SPDR S&P 600 ETF is a solid way to gain exposure to this market segment.
