Big stocks won when markets rose. They are winning again in the selloff.

Big Stocks Won When Markets Rose. They Are Winning Again in the Selloff. ALEXANDRA CITRIN-SAFADI/WSJ
Big Stocks Won When Markets Rose. They Are Winning Again in the Selloff. ALEXANDRA CITRIN-SAFADI/WSJ

Summary

High rates and war fears hit smaller stocks harder—driving an unusual split in two of the major U.S. indexes.

One of the biggest concerns amid the run-up in stocks in the first three months of the year was that the rally was dominated by the biggest companies. As it sold off this month, the market became even more top heavy. Blame the Fed, and a change in how investors react to it.

This isn’t how it was supposed to be. For weeks now Wall Street has been pushing the idea that the market is broadening out beyond the “Magnificent Seven" Big Tech stocks, helped by the dismal performance this year of formerly magnificent Tesla (down 41%) and Apple (down 14%).

It might be broader than seven stocks, but bigger continued to be better in April, with the notable exception of Friday, when several of the biggest stocks plunged. Divide the S&P 500 up into 10 groups and there is an almost-perfect descent in performance by size: from the biggest 50 down just 4.5%, to the smallest 50 down 8.6%. The pattern is more regular than it was in the first three months of the year, when the big were so obviously getting bigger.

This isn’t just about the S&P, which after all consists of the 500 or so largest stocks. The Russell 2000 index of smaller companies lagged badly behind on the way up, with its price rising less than 5% against 10% for the S&P in the first quarter. Then on the way down this month the Russell 2000 has fallen more, down 8.3% against a 5.5% decline for the S&P. The Russell Microcap index, which includes even the tiniest companies, rose even less and fell even more.

The main cause is interest rates, plus more recently fears about a wider Middle East war. Both hurt smaller companies far more than bigger ones—and for some bigger companies, higher rates even boosted the bottom line.

The impact of higher rates is part of the two-speed economy that has resulted from sharp rate rises, and then this year the evaporation of hopes for multiple rate cuts. Big companies are insulated from the impact of higher rates because they used their easy access to bond markets to lock in superlow-cost debt for a long time when rates were low. Many of the very biggest, particularly Big Tech stocks, are also sitting on huge piles of cash, which are earning more thanks to rate rises.

By contrast, smaller firms find it hard to issue bonds and borrow far more at a floating rate. As with poorer consumers who borrow on their credit cards, the cost of this debt has soared as the Fed tightened, hitting the profits of smaller companies. Goldman Sachs analysts calculate that almost a third of Russell 2000 debt is at a floating rate, compared with 6% for the S&P 500.

On top of that, smaller companies as a group have higher debt compared with earnings and more volatile earnings—making them less appealing when there is a flight to quality amid war fears.

This all shows up as the Russell 2000 moving strongly in the opposite direction to bond yields. Meanwhile there has been no link between moves in bond yields and the top 50 stocks this year—an unusual split between the two indexes.

Surprisingly, the excitement about artificial intelligence isn’t a great explanation for the biggest stocks winning. Sure, giant chip maker Nvidia soared 91% this year to its peak on March 25, but since then it is down 15%, including a plunge of 10% Friday, much worse than the Russell 2000. Just as it dragged up the performance of big stocks in the first quarter, it should have dragged them down this month—yet they still beat their smaller brethren. Further, AI can’t explain why there is such a neat pattern of outperformance by size. This isn’t just about a handful of huge AI winners.

The pattern is surprising for anyone who remembers 2022 and suggests investors are much more focused on profits now. In 2022, Big Tech and other growth stocks were crushed as valuations collapsed, even though profits were fine. The argument—a good one—was that for growth stocks, profit is further in the future than for cheap value stocks, so higher long-term bond yields should make those future profits less valuable. A bird in the hand is worth more when it earns a safe 4%+ yield than it is at 0%—so those two in the bush become less appealing.

The difference this time is that rates were high to start with. The 10-year Treasury lost almost 20% in price terms in 2022 as yields rose, while this year it is down only 6%. Back then investors sold growth much more than value, without much attention to size (both the largest and smallest members of the S&P did badly). This year investors bought growth more than value, while size mattered more.

This makes sense. As well as rate changes having a smaller impact when rates are already high than when they are superlow, investors have wised up to the varying effects of higher rates on the bottom line. Valuations, while still very high, are also lower than at the end of 2021. That doesn’t make the big-stock wins any easier to stomach for investors who keep hoping that smaller stocks will one day prove their worth.

Write to James Mackintosh at james.mackintosh@wsj.com

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