Editor’s note: The following was adapted from our 2Q 2024 Commentary

As the U.S. economy absorbs the most aggressive Federal Reserve tightening cycle in recent history, the historically elusive "soft landing" increasingly is becoming the base case for investors. While economic growth has decelerated, it remains positive, defying earlier fears of a recession. Consumers, however, are feeling the pinch of cumulative inflation, causing them to tighten their belts, trade down from premium to discount items, and lean more heavily on credit cards when making purchases.

The Consumer Tightrope

Lower-end consumers are feeling the greatest impact from inflation, while high-end consumers continue to largely drive the economy. Notably, affluent Americans have seen a dramatic increase in household wealth since prior to the pandemic. The surge in housing prices, stock market rallies, and higher returns on cash relative to the days of “zero-interest-rate policy” have all contributed to this wealth effect.

The Personal Consumption Expenditures (PCE) Index, provided by the Bureau of Economic Analysis, is a measure of the prices U.S. consumers pay for goods and services.

Meanwhile, inflation, although still positive, continues to slowly approach the Fed’s 2% target. As shown in the chart above, the core Personal Consumption Expenditures (PCE) Index, said to be the central bank’s preferred inflation metric, declined to 2.6% at last reading. Additionally, the jobs market, while still strong, saw the unemployment rate tick above 4% in June for the first time since November of 2021. Should these trends persist, it’s likely the Fed may begin cutting rates sometime this fall.

A Narrow Path to Performance

“The market" continued to hit new highs on what seemed like a daily basis during the second quarter. The use of quotation marks is intentional, as it is increasingly difficult to discuss the behavior of the stock market in terms of the S&P 500 Index alone. This is due to the ever-increasing concentration within the Index, as the top 10 stocks now constitute an eye-popping 37% of the Index's market capitalization—the highest on record. When viewing the market beyond the handful of mega-cap (mostly technology stock) darlings, a significantly different picture emerges.

As the chart below depicts, the average stock in the S&P 500 (represented by the S&P 500 Equal-weighted Index) was down during the quarter, with small-cap stocks (S&P Small-Cap 600) faring even worse.

A Rough Quarter

Reminiscent of the Dotcom Era

It increasingly appears we are in a period of performance-chasing and FOMO (fear of missing out), as trillions of dollars flow into these handful of growth stocks. In the second quarter alone, NVIDIA Corp., still riding the wave of artificial intelligence exuberance, added over $800 billion in market cap, ending the quarter with a market valuation exceeding $3 trillion.

The recent surge in growth stocks, particularly in companies like NVIDIA that are riding the AI wave, has echoes of the late 1990s tech bubble. Recent conversations at family cookouts about how much NVIDIA family members own are reminiscent of similar discussions about Janus Funds during the summer of 1999.

We view this as a dangerous set up for many investors, including those who have the bulk of their wealth in index funds. Should there be a rotation out of beloved megacap stocks, as there was following the “dotcom bubble,” the impact on the market could be dramatic, perhaps even more so than the turn of the century move, given the top-heavy concentration existing today. A recent Wall Street Journal article reminded readers that, following the bursting of that tech bubble, small-cap stocks, as represented by the Russell 2000, beat the S&P 500 by 114% through 2014.

An Increasingly Concentrated Bet

A Potential Turning Point

It is possible a Fed easing cycle could turn the tide, given the “higher-for-longer” interest rate environment has been extra burdensome on smaller companies. These companies often have less readily available access to capital markets to fund operations and must resort to higher-cost, often floating-rate, debt. Should the market begin to discount lower interest rates, smaller-cap companies could see significant relative outperformance.

A recent reaction to a softer Consumer Price Index (CPI) reading could be foreshadowing. On July 11, the June CPI fell 0.1% versus forecasts of a 0.1% increase from May. Despite year-over-year inflation coming in at 3%, still above the Fed’s 2% target, the lower month-over-month number raised expectations of a Fed rate cut in the coming months, and a powerful rotation ensued. This one-day move saw the “Magnificent 7” megacap stocks lose over $500 billion in market value, while the small-cap Russell 2000 gained 3.6% on the day. Was this a proverbial “canary in the coal mine”? Only time will tell, but we feel Prospector’s investment strategies are well positioned to navigate should market leadership continue to broaden.

We share more in our 2Q 2024 Commentary.