The stock market had a mixed month in July. The S&P 500 continued on its breakneck pace for the first part of the month, setting yet another all-time high. But it started to falter mid-month, giving back all of its gains for July at one point.
As investors sold out of stocks in the S&P 500, it was clear where they were putting their money. Small-cap stocks soared amid the drop in the S&P 500 in what the media is calling "the great rotation." The SPDR Portfolio S&P 600 Small Cap ETF (NYSEMKT: SPSM) climbed 10.8% in July while the SPDR S&P 500 ETF (NYSEMKT: SPY) finished the month just 1.2% higher.
There are good reasons to expect small caps to continue outperforming large-cap stocks for some time. Two important market indicators suggest this may be just the start of the rally in the S&P 600 .
Image source: Getty Images.
U.S. money supply is growing again
There was strong growth in the money supply in 2020 as the Federal Reserve dropped interest rates and the government provided stimulus checks to consumers. However, a slowdown in money supply growth started to emerge in 2021. The slowing growth came to a head in 2022, eventually resulting in a year-over-year contraction in the money supply.
Money supply growth remained in negative territory until earlier this year, when it climbed 0.6% in April and May. In June, the most recent reading, M2 money supply (cash and easily accessible cash equivalents like CDs) increased nearly 1% year over year. And if the Fed cuts interest rates later this year, as expected, the rate should continue accelerating.
US M2 Money Supply YoY data by YCharts
That's extremely bullish for small-cap and mid-cap stocks, notes Khuram Chaudhry, Head of European Quantitative Strategy at J.P. Morgan Securities. He points out that stock market concentration typically rises as money supply growth falls and vice versa. So, as the money supply increases small companies have more access to cash and their cost of debt declines. As a result, concentration should shrink and investors should shift investments from the biggest companies to smaller stocks.
The valuation gap remains high
The valuation gap between the S&P 500 and S&P 600 reached the highest level it's seen since the start of the century at the beginning of July. As small caps have outperformed, that gap has closed somewhat, but it is still notably high.
As of the end of July, the forward P/E of the S&P 500 was 20.6; the S&P 600 had a forward P/E of 15.4. That gap of 5.2 is not as wide as the 7.4 point gap in early July, but it's still one of the highest levels seen since 2001. (The gap did climb above this level in late 2021 through early 2022.)
When the gap between large caps and small caps reaches this level, it usually leads to outperformance from small caps. From the end of 2001 through the end of 2011, the S&P 600 produced a total return of 98% versus 33% for the S&P 500. The S&P 600 also held up better than the S&P 500 in 2022, resulting in the valuation gap shrinking again.
Even after the strong performance of the S&P 600, it still looks like there's a long way to go before the valuation gap between small caps and large caps normalizes. Theoretically, small caps should support higher valuations than large caps, as smaller companies can typically grow faster than larger companies. Indeed, the S&P 600 sported a higher forward P/E than the S&P 500 for about 15 years from 2003 to 2018.
Why the S&P 600?
The S&P 600 isn't the most commonly used index for tracking small-cap stocks. That title goes to the Russell 2000 . Several high-profile investors have made big bets on Russell 2000 index funds ahead of the great rotation.
However, the S&P 600 requires companies to show consistent profits to include them in the index. That profitability requirement increases the quality of companies in the index. That means the S&P 600 will tilt more toward value stocks than growth stocks . But small-cap growth stocks, as a group, are historically the worst-performing segment of the market. Therefore, I favor the S&P 600 over the Russell 2000.
That said, there are many different ways to invest and interpret the above indicators. And more importantly, you should always keep in mind that no market indicator (or analyst) is able to predict the future. But if you missed the initial move in small-cap stocks, it still looks like there's a lot of room for them to run higher, and the SPDR S&P 600 ETF is a great way to invest in that segment of the market.
JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase. The Motley Fool has a disclosure policy .
Most Popular
Comments / 0