Much of the current bull market has been dominated by small cap and value stocks, but a shift has occurred. Historically, large cap stocks outperform for an extended time in the later stages of a bull following a period of small cap dominance. In the current cycle, the transition began in mid-2006 and became more pronounced in the second half of 2007. Fisher Investments believes this trend will persist in 2008.
As the shift continues, skeptics will be bothered by the fact fewer and fewer stocks are beating the market, citing the number of stocks underperforming compared to relatively fewer making gains as a justification for a bearish posture. This is typically referred to as negative “market breadth.” Technical traders believe times of negative market breadth are a harbinger for negative markets. But times where market breadth turns negative doesn’t necessarily predict a down stock market. The last time breadth turned negative was 1998—a period when the previous bull market had yet far to run.
Stock markets are composed mostly of small cap stocks by number but relatively few large caps. In fact, of the universe of nearly 25,000 global stocks, only 81 are larger than the weighted average market capitalization of the MSCI World Index. Though they’re the minority by count, those 81 companies are so massive by cap they pull the smaller companies up to the average. Thus, when big cap stocks lead, fewer companies will outperform the market.
This may sound convoluted, but the math is simple. A companies’ weight in an index is determined by its market capitalization. So, a company as huge as Exxon Mobil, which is about $500 billion in size, dwarfs many times the very small companies of a few hundred million dollars at the other end of the spectrum. Thus, Exxon carries a very large weight in the index. The sum of the largest stocks in the index usually carries a very large weight, that is, they account for a very high percentage of the total.
This style change is the result of an important fundamental shift pertaining to corporate access to capital. Clearly, the smaller the company, the lower its credit rating. Conversely, the largest companies by market capitalization tend to have the most sterling credit ratings. This distinction becomes hyperbolic with the very largest stocks, or “super caps,” which tend to uniformly have the best credit ratings and the cheapest borrowing costs. In fact, all the companies today with AAA credit ratings are super-caps. (Source: Thomson Datastream.)
In the first part of the bull market when small caps outperformed, the yield spread between risky debt and investment grade debt was shrinking. That is, it was becoming easier for small caps to borrow relative to large caps. This is a significant reason small caps outperformed in those years.
Today, the spread between investment grade and riskier debt is widening. This means it’s becoming relatively easier for large companies to borrow.
An easier financing environment for large caps, or conversely, a more difficult financing environment for small caps, points to a period of outperformance for large caps. Fisher Investments believes this trend will persist into the period ahead.
*Written as of February 06, 2008. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.