Only Price Matters

The last market update discussed how we were positioning for higher highs even after the “V” shaped recovery from the March lows. There remains a huge amount of disbelief in the strength of this market, but as long as the internal indicators and the ultimate arbitrator, price, are saying there are more buyers than sellers then we will ride the wave higher.

Saying “price” is the only thing that matters sounds glib and too simplistic, but when you think of price as an aggregate collection of all available information combined with human behavioral quirks then it starts to sound more like an AI output to an immensely complicated question. Stock prices operate according to collective logic not to any individual investor’s beliefs and expectations or even manipulations. Many investors often assume that certain events like war, inflation, elections, interest rates, or valuations should strongly affect stock prices and even get very frustrated when the market reacts differently. The collective consensus determines how much weight each factor deserves at any given time. Sometimes it’s unemployment, other times it’s inflation, or housing starts, or valuations, or earnings. The one constant is that it’s always changing and trending, but it doesn't matter because it ultimately gets reflected in one thing: price.

Investors, including myself early in my career, confuse being factually correct with being profitable. For many, it just makes more sense to invest in a company that makes money or pays dividends than one that has massive debts and hemorrhage money. But buying an “unprofitable” company and selling it for a higher price does produce real profits that we then can use to buy groceries and things. Even Michael Burry of “Big Short” fame was factually correct in seeing the housing crisis, but his fund was down massively month after month because he was early to the trade and investors didn’t care until they had to. He eventually made money, but most people would have been broke after several months of 60% drawdowns. Markets reflect collective expectations, sentiment, and positioning, not just raw facts.  Investors frequently fight market trends because they believe the market “should” care about something else. This usually ends poorly.

Right now, markets are screaming higher. We hear the consumer is dead but Best Buy is up almost 20% today after earnings and say they are moving huge amounts of $7,000 TVs. But it’s not just the high-end consumer participating, the Dollar Tree and Kohls are up nearly the same amount. They say software is dead because AI will do everything, but Microsoft is spiking, as is Oracle, and the whole index has rallied 30% since last month. And next month we will see the largest IPO in history by far in SpaceX. I personally think the valuation is crazy – a $2 trillion IPO. But who am I to judge? The market might push it to $10 trillion in no time, or we will all collectively decide that valuations matter again. Only time will tell, but it will be reflected in the price. The markets aren’t moral and do not rise and fall based on fairness, ethics, or politics – just supply and demand. In the end, price is the final expression of all the opinions, information, and emotions in the marketplace and price is the only thing that pays.

Positioning for Higher Highs

In the last market update we discussed the positioning of market participants and key levels that the indices were bouncing around. We identified the indices’ level as a polarity zone and were predicting that a decisive move was coming, likely to the upside. As it turned out, that was accurate forecasting. Many traders were caught doubling down and selling into an already depressed market after the S&P declined by roughly 9%. But as is often the case, the market humbled them and they were forced to cover those short positions as buyers stepped back into the market, driving prices decisively higher. The “V” shaped recovery was one of the fastest in history putting it in the 99th percentile of market returns in a two-week span. The semiconductor index was up for an incredible 16 straight days, rallying over 30%.

Large cap tech and semiconductors had been flat or going down while the rest of the market was advancing higher over the last several months. The general thesis is that set-ups like these resolve in the direction of the overall trend. We were still getting signals that the bull market was alive even as the indices pulled back. Underneath the surface more stocks were making new highs rather than new lows and participation was continuing to broaden. Now here we are a few weeks later and all major indices are sitting near all-time highs once again, and once again sentiment is terrible, setting the stage for more market rallying as FOMO sets in and investors are forced to buy in at higher prices.

Nearly 80% of Americans say economic conditions are “poor” or “only fair.” While this is troubling on a human level, it is welcoming as an investor. Because by the time most people think economic conditions are excellent, they likely won’t be. In 2007, when people were feeling great about investing in real estate, buying a second home, or refinancing to take cash out of their house because prices were never going down, that was the time to get out. Same with stocks. If people are reluctant to buy, then it’s probably still a good time to be a buyer. Even, and especially, in advancing markets. Human behavior is silly but at least it’s predictable. It seems like nothing makes an investor nervous like a falling market except for a rising one. The old adage of “buy low, sell high” is a recipe for disaster. It’s much easier to buy high and sell higher. Trying to buy low is often like trying to catch a falling knife. You’re probably going to get hurt. Hunting for something cheap and hoping it stops falling in price is not a strategy, it’s ego. The market punishes ego. The whole thing about human behavior is that we are trend followers. Brand popularity trends, style trends, and so do stock prices. It’s much easier to merge into traffic and exit down the road than stand in front and hope it stops.

Surveys are telling us investors are reluctant right now to own more stocks and are more eager to keep cash on the sideline because of the “high prices.” Yes, both the S&P 500 and Nasdaq recently closed at all-time highs, but that’s not something to fade, that is something to respect. This is how bull markets look. They don’t look cheap, they don’t wait for you to get in. They just keep going. And the irony is that if prices were to meaningfully decrease it is even more unlikely that these same people would want to buy. The data backs it up. On every timescale besides super short, buying at all-time highs has better forward returns than buying on a random day. So, embrace the new highs and try not to get stuck in the mindset of looking to buy low and hoping.

Polarity and Positioning

The stock market is in what we call a polarity zone - a price range with equal resistance above and below. The Nasdaq peaked in November and the S&P in February and since then both indices have been bouncing within a tight range. In that time, dividend paying stocks and traditional value stocks have demonstrated relative strength, and the energy sector has been on fire. But it remains to be seen which pole the broader market will gravitate towards. Will it be dragged lower and follow software and the like or will it break out higher following industrial and energy sectors? To find our answer (or at least make an educated guess) we have to look for clues in things like “advance decline” metrics, number of sectors above or below their 200-day moving average, earnings report reactions, and fund flows. We also want to see former leaders lead, and economically important sectors show strength (for example, technology and banks as discussed last month). Currently, semiconductors are at a make-or-break moment. The sector has bounced up or down from this level 5 times since last October. The longer a stock or sector gets stuck on a polarity zone, the greater the probability of a large move in one direction or the other, once the breakout occurs.

Market participants have been bracing for chaos and a breakdown in the markets for months now. In the fall when the major indices peaked and began moving sideways the talk was about the over-concentration by a few large companies in our stock market, and how AI was rapidly both making every industry more efficient and destroying them at the same time. And in truth investors were over positioned in a few companies so individuals and institutions started unwinding those trades. Headlines about the market crash in software, venture capital, and private equity lending have stoked fears but under the hood the story has been a little different. The number of stocks making new lows on the NYSE is shrinking not expanding even as indices drift lower. Much of the selling, especially among the larger companies, has already happened. They were overextended in a few sectors and have since reined that in. That’s what has been pulling the market lower. But if stocks were really breaking down then we would see broader participation to the downside. So, where are all the sellers if everything is falling apart and war and oil and AI are here to usher in the new bear market? It’s possible that they are already gone. Investors have spent the past 5 months preparing for a crash and already loaded up on cash and short positions. Contrary to our instincts, it’s not narratives that drive the market, it’s positioning. Narratives exist to give us a story to try to make sense of the unknowable.

Goldman Sachs is estimated to have sold roughly $190 billion in in equities in the past month and are now net short by about $50 billion. This means they are guaranteed buyers of roughly $50 billion worth of stock in the near future. They are not alone. Historically, when institutions are at a net short position in the market this is usually not indicative of the beginning of a downturn. It usually signals we are closer to the end of one. Before the monster move in equities today the major indices were down about 10% from their highs. So, a sizable move lower has already taken place and if major sellers have already sold this would be a logical place for momentum to flip in the other direction. The bounce we are seeing today (3/31) is right off that major polarity zone and a decisive thrust in favor of the bulls. This is exactly what we would expect to see when underneath the surface there are actually more stocks going up than down (even as indices fall) and the percentage of stocks above their 200-day moving average is rising. Yesterday, stocks got hammered but financial stocks were rising. You don’t get sustained rallies and bull markets without a healthy financial sector, so this was a very telling and positive sign.

If everyone is saying stocks are falling apart and the data is saying otherwise trust the data. After stocks break out of this polarity zone a new narrative will emerge but we will know it was always just about positioning the whole time.

Financial and Tech Sectors

Technology companies have largely carried the stock market higher for the past decade-plus. Their earnings and valuations have exploded with the internet and digital economy, even eclipsing many of the lofty predictions made in the late 1990’s during the tech bubble. E-commerce and machine learning are now normal parts of our everyday life. We even now have digital currencies and blockchain technologies operating in meaningful ways and not just wild speculation in “meme coins”. However, below all of this we still have large financial institutions and regional banks facilitating the movement of money racing through the digital economy. The financial sector is the one sector that the bull market can not afford to lose.

Some may not have noticed, but the tech sector has not advanced since October and has in fact declined roughly 10%, but the S&P and Dow Jones indices are at or near all-time highs because the rest of the sectors are advancing (not to mention the breakout in international stocks). With a well-diversified portfolio, the downturn and stagnation in tech has not made a huge impact. However, if the selling pressure in tech bleeds into other areas, specifically financial companies, that would be a red flag. We simply don’t get sustained bull markets in the US without companies in the asset management space, banks, and mortgage companies doing well. When they are not doing well, problems seem to follow. Over the past year bank stocks in general are up and small banks in particular have performed very well, up over 17%, but large cap financial companies are meaningfully underperforming. In fact, relative to the S&P 500 that area of the market is at its lowest level in five years. The underlying advancing trend in the market tells us that this is most likely a shake-out or normal sell-off after years of advancing, or possibly a rotation by money managers into other areas that are doing better like materials and commodities. Rotation is normal and healthy in a bull market, but this divergence is something we are keeping an eye on since the market often sniffs out problems before they are evident in the real economy. Financials are not just another sector; they are the oil in the engine. When credit expands and capital flows freely, the gears of the economy run smoothly. The coming weeks will be very important to see if these bellwethers of the economy reassert their leadership or if their weakness portends trouble ahead.

Similar to what we’ve seen in the financial sector over the past month, we’ve seen in the tech sector over the past 3-4 months. The bellwethers of that industry (Microsoft, Amazon, Meta, etc) have been stuck in the mud or declined while their small-cap companions have roared higher. As noted above and many times before, rotation is normal and that’s why we diversify. But if we don’t get some reassertion of leadership and see renewed confidence in the big boys it could be a rough spring. As we noted in our year-end market letter, we expected the bull market to continue before facing headwinds in spring. That would be normal for a bull market in this part of the cycle. That does not mean we will enter a sustained bear market, more like a digestion of gains before advancing further.

Pessimism has crept in as investors are concerned about valuations and AI eating every industry under the sun. In the software space investors are taking the approach of shoot first, ask questions later – chopping down dozens of companies along the way. This mentality might bleed into other industries before it gets better but that should be viewed as a buying opportunity. Blind selling is rarely the smart investment move. Software giants like Microsoft and Salesforce are posting massive profits with billions in free cash flow and getting punished in the market. To think these tech companies based here in the Silicon Valley will not integrate and re-invent themselves with the new AI technologies being developed in their backyard is hard to imagine. In fact, they are doing quite the opposite. They are actively funding and investing in the technologies that are supposed to disrupt and dethrone them. The big players are not going away and the overall market strength and broadening of participation of advancing stocks likely points to a big catch-up trade in the not-too-distant future for the former market leaders.

Rotation and Commodities

The bull market has so far continued into the new year with major indices advancing roughly 1% in January. The sectors have been playing a game of leapfrog where they take turns jumping over each other and advancing. Last year’s winners are pausing, and last year’s laggards are leaping. Energy, one of the worst performing sectors over the last twelve months has so far been the top performer this year. The group is up over 14% and is breaking out of a 12-year base. The path of least resistance is higher. Financials, who had an outstanding year in 2025 are now down 3% to start this one. This is called sector rotation and a staple of all healthy bull markets of the past. Tech is another example. Many investors hold a high percentage of technology in their portfolios as their market caps have ballooned due to the fact that they have dominated for so long and become the backbone of the modern economy. Beginning in October, however, they took a breather as money flowed from tech into other sectors which leapt ahead. Technology actually became the weakest sector in the S&P 500 during that period. But over the last few weeks that has started to change. This is former leadership trying to retake their position and a hallmark of bull market rotation. The earnings remain stellar for the mega-cap tech firms but the reactions to the earnings reports have been mixed. In any case, price usually resolves in the direction of the underlying trend, so the sell-off in Microsoft, for example, will likely be short-lived as they start to look cheap relative to other tech companies and the overall market.

Semiconductors are also looking strong again. Just the other day they closed at their highest level both on an absolute basis and relative to the S&P 500. Within the sector of technology, semiconductors are the engine that makes it go. If the trend continues, this should pull up the whole tech space, mega-caps and all, and pull the indices to higher levels. That’s what strong leadership in a bull market does. Tech matters a lot. And stepping back you can see why. It’s the largest weighting in the S&P 500 by a bunch, making up over 35% of the index and accounting for over 50% of the Nasdaq index. So having them step back into a leadership position is not a bad thing for stocks.

Before we go any further, we have to mention commodities. The price of gold has doubled in the last year and silver has nearly quadrupled, up 60% in the last month alone despite being down a whopping 27% today. Copper had its biggest day in years the other day and geopolitically there are talks of annexing Greenland to take control of its precious metals. When commodities go wild rarely is that a good thing for the consumer. Commodities often act as a leading indicator of inflation and bond prices. We have already seen the yield curve steepen meaning that despite what the Fed is doing with interest rates on the shorter-term, long-term notes and things like mortgages are remaining stubbornly high or are even increasing. A typical scenario plays out as follows: gold goes higher, then silver, then other precious metals and copper, and then energy. Then of course inflation. The bond market is pricing in slowing growth and higher prices (inflation). Perhaps this is why we have seen energy stocks catch a bid despite oil and gas prices being at about the same level they were in 2005. Crude is sitting around $65 a barrel. In 2008 it was over $140 and even in early 2022 it was around $120. If we see crude oil (and thus other petroleum products) do what gold, silver, platinum, and even beef and coffee have done then it could be rough on the consumer. The bull market is still on, but commodities are trying to elbow in and cause a shake-up. We will be monitoring closely and trying to position accordingly.

Bull of 2025

Twenty twenty-five has come to a close and the markets are posting yet another strong year. Market participants should be gleeful, but anxiety remains elevated as the fear gage, VIX, rests at 16. A level rarely breached from all of 2013 to 2020. I suppose it’s only human to worry about what could go wrong when (market speaking) things are looking so good. After all, the NYSE Composite and Russell 3000 (accounting for 98% of all stocks) just closed at all-time highs. The Dow Jones Industrial Average also closed at new highs and financials continue to post new highs all across the globe. Healthy bull markets are reliant on healthy financials. Additionally, every sector in the S&P 500 is trading above it’s 200-day moving average except for one – consumer staples. This is exactly what you want to see in healthy bull markets. We are a consumer-based economy and traders and portfolio managers know that when the music is coming to an end and they need a place to park their cash it’s consumer staples (toothpaste and such) they turn to. When markets are still in uptrends and investment appetite remains robust consumer staples lag. All this to say 2025 is coming to an end but the bull market is not. Until the trend tells us otherwise the evidence is in favor of staying long stocks.

This time of year it’s always fun (and hopefully beneficial) to predict what we will see in the markets in the year ahead. Just as farmers have a Famers Almanac investors have a trader’s almanac. We can look to it to see what happened in the past in similar circumstances. In this case, the upcoming year happens to be year two of the four-year presidential cycle, historically the weakest for stocks. In previous cases the trend of sideways or upward already in place continued for the first part of the year before getting wonky in quarters 2 and 3. Usually things pick back up again in the fall however, as a strong seasonal tailwind kicks in before Halloween and runs into the next year. Obviously, things do not have to work out this way, and it might sound like tarot card reading to some. But there is a fair amount of history to back it up and we do know that behaviors and prices trend over time. That doesn’t mean we can just rigidly believe in our forecasting and tune out what is right in front of us. The markets have a long history of making fools out of investors living in certainties. The best approach is to monitor whether the current trends are either in-step or breaking with historical norms while at the same time scanning below the surface to see if anything is starting to deteriorate underneath. Things like the advance-decline metric, new highs vs new lows ratio, and several others. Additionally, we’ll look to see if aggressive sectors like technology and consumer discretionary are showing signs of weakness. Then, we’ll check overseas to see if the broader and emerging markets are still in uptrends. Lastly, we’ll check in on areas that are in a downtrend and determine if they are likely to be the culprits of the next bear market. For example, previously we discussed the drawdown in high flying stocks like Palantir and quantum computing stocks. But since their free-fall in November things have stabilized. If a culprit can’t easily be identified there probably isn’t one yet. If after all this analysis things still look positive, then they likely are.

In short, our New Year’s prediction is for generally positive winter and early spring, perhaps a rough late spring and summer, and then a renewed uptrend in the fall. Only time will tell, but we’ll be watching and adjusting accordingly. Happy New Year!

Bear Sightings

In the last market update we discussed looking for signs of a bear market. Well, a few weeks ago we got our wish and the bears showed up. In the span of a little over a week the markets got slammed with a 6% drawdown. However, the bulls licked their wounds, regrouped and clawed back most of the losses since then. The bear raid did spook some investors though; volatility picked up significantly and the VIX (fear index) shot up. It’s still at slightly elevated levels even after coming down over the past several sessions. Adding anxiety, the financial sector has been stuck in a rut and trading at about the same level as it did in March. Banks peaked in mid-September and have been looking for direction ever since (but still just 2.5% off their highs). Investors want more assurances that inflation is under control and debt (both federal and private) is manageable. The Mag-7 stocks (where many investors are concentrated) peaked in late October and have also been looking for a decisive path forward. In healthy and robust bull markets you want to see your leaders lead (tech, in this case) and financials to remain healthy, so these are two areas we are watching closely.

Tech still looks strong and has been consistently leading the market higher this whole cycle (both in the shorter term and going all the way back to 2008). Apple is at new highs, Google is up over 60% this year, and Nvidia keeps posting record profits. However, there have been growing concerns over the use of debt by the major tech companies to fuel their AI chip purchases from the likes of Nvidia. Hundreds of billions of dollars are being spent to upgrade processing power in the war for the best AI. Nonetheless, credit spreads (a gauge of health and risk in the debt market) remain very tight. When creditworthiness deteriorates due to overleverage or underlying problems within a business sector, credit spreads do not remain tight, they widen. This has preceded every major financial crisis and is scrutinized by the Federal Reserve (and market participants). When things get bad enough the Fed must step in and “backstop” banks that hold large amounts of bad debt to stop a “run on the bank.” Thankfully, bank balance sheets look healthy and well capitalized despite the added leverage in the system by large borrowers like Amazon and Meta. Investors just want a little more reassurance that this business model and these profits will continue before pushing bank valuations higher.

The real bear sightings have taken place in the speculative tech sector. Companies that have rocketed higher this cycle and been the favorites of day traders, like Palantir and quantum stocks, are down well over 20% and many are down close to 60%. At the index level this doesn’t make much of a difference. Nonetheless, it does show that fear is creeping in from the margins and investors are cashing out of names that have done the best over the past few months. We would prefer to see risk appetite remain high so as to be more confident that investors are still bullish, but seeing the most important sectors holding up along with the major averages is still a very good sign.  Even with the recent drawdown, more stocks are going up than going down and the bull appetite remains robust. There may have been some bear sightings, but this is still a bull market.

Looking For the Bear

Stocks don’t go up in a straight line, but it sort of feels that way since the Tariff Tantrum sell-off in April. The rally that ensued has lifted the market over 40% from the lows of spring. Along the way there have been some pullbacks, but all were short-lived. Yet each time stocks retreated pundits began sounding alarm bells of a bear market. We too have been looking for the bear, but it is proving rather elusive. Every dip is being bought up and when cracks emerge, they seem to be quickly repaired. Across the market we are seeing bull market behavior. For example, few weeks ago there was a mini banking scare when a midsize auto parts maker filed for bankruptcy and billions of dollars in bonds held by banks vanished as the assets plummeted in value. There was fear of contagion and shares in regional banks across the market fell in price. Jamie Dimon, head of JP Morgan further stoked fears when he said there is rarely just one cockroach. Nevertheless, the buyers stepped back in, and bank shares found support. This is not seen in weak or bear markets. We are seeing similar behavior in the homebuilders. Stubbornly high interest rates have been wearing on the housing market for a few years now, but even in this rough market shares in homebuilding stocks are roughly flat on the year. There will always be reasons to be fearful, but when the market is digesting bad news and still holding ground or marching higher that is usually a very positive indicator.

Looking past headlines promising of dangers ahead can be difficult, but price is the only thing that pays an investor and so far, prices have been moving higher this year. Furthermore, we are now entering the most bullish time of the calendar after gritting through what is historically a rough month. Comparing price action with seasonal trends helps us gage the sentiment in the market. When prices are supposed to rise and they do rise that tells us something but when they are supposed to fall and they rise that tells us a lot more (and vice versa). Other evidence suggesting we are in rally mode is the continued strength in “risk-on” assets. We determine this by looking at specific industry group ratios. This helps us determine the risk appetite in the market. One good ratio is high-beta stock performance to low-volatility stock performance. These groups often perform differently during different points in the market cycle. Historically, when high-beta stocks (ones that moves in the same direction but to a greater extent than the overall market) outperform their low-beta (low-volatility) counterparts, that is telling us that investors are willing to take on more risk. In weaker stock market environments or market downturns you see investors pulling money from riskier stocks and putting them into “safer” low-volatility industries like consumer staples. With the logic being that no matter what the economy is doing, people are always going to be buying things like toilet paper, soap, and toothpaste.

We can also test this by looking at a company like Tesla, one of the top holdings in Invesco’s high-beta ETF. It is on the verge of completing a massive base and breaking out to new highs not seen in almost 5 years. With a trailing P/E of nearly 300 this is not a fundamental or earnings story. This is a story of investors jumping in to take on more risk with the hope of outsized gains in an advancing market. High-beta investing being fashionable is not a bearish indicator.

One day the bear will show up, but before it does so in full force it will likely start making its presence known underneath the surface. As of now evidence is still in favor of the bulls.

Small-Caps Secular Trend

Until the other day, it had been almost three years since small-cap stocks and the Russell 2000 index made new highs. Meanwhile, the largest companies comprising the S&P 500 index have already done it over a dozen times this year alone. But the trend is changing, and the data is backing it up. Small-cap indices are knocking on the door, ready to break out much higher. Last month we discussed how small-caps were leading the charge with the help of things like regional banks and industrials creating relative strength for the index when compared to large-cap indices. More factors are lining up, adding fuel to the trend. The Fed is cutting rates, giving a boost to smaller companies with thinner customer bases who typically are more reliant on credit than their cash-cow big brothers. So even small moves in interest rates affect them much more. Traders seem to be taking notice and momentum is picking up. We are already seeing speculative growth stocks go on a tear in things like uranium, Bitcoin miners, and quantum computing. Globally, small caps are already taking the reins in countries like China, Brazil, and others. Seasonality should also start to come into play for the year-end, as the fourth quarter tends to favor small-caps historically.

 After years of outperformance by the mega-cap leaders of the S&P 500 and Nasdaq, the Russell 2000 has some catching up to do, and that could bode well for the little guys. There’s an old adage on Wall Street, “the bigger the base, the higher in space.” With the small-cap index pushing up on new highs for the first time in almost 1000 days, this marks the longest drought for the index ever. And the relative underperformance has gone on even longer. This makes for a very long base that could serve as a launchpad. Even coming out of the 2008 financial crisis it only took 959 days to retrace the losses. Currently, we sit at a logical time in the cycle (middle of the bull market) and at a logical weighting (large caps are at their heaviest weighting in the indices in over 20 years) for the trend to shift. Long, secular trends like this are great to catch because they can carry on for years. It will take a while for money managers to unwind their heavy weightings in the large-cap space. After all, these are the biggest and best companies in the world, and they have dominated the market for years.

Large endowment funds and institutions move very slowly, and it may take many cycles of outperformance by the non-Mag-7s for money managers to meaningfully change their allocations. While it is important to pay homage to the ones that have produced the biggest gains, it’s also important to stay sharp and identify areas of potential outperformance. Pairing that with core holdings (often mega-cap) is an effective way to maximize growth and minimize taxes. Just like in sports, positioning matters. Putting yourself in position to make a play is more than half the battle. We are still in the early innings because the media outlets are not talking about it being “small-cap season.” That usually happens late in the trend. And as long as we continue to see record levels of “short interest” in small-caps while their indices charge to new highs it lets us know that we are in position to capture further gains. Anyone that is “shorting” a stock is just a guaranteed buyer in the future. Given the recent trends, the odds are they will be buyers at higher levels than today.

Small Caps and Banks

Investors have been piling into the mega-cap tech companies as they build out their AI infrastructure and rain in profits. The growth and influence of these huge companies over the last decade-plus has been astounding. The Mag 7 (NVDA, MSFT, AAPL, AMZN, META, GOOG, TSLA) now account for over 30% of the S&P 500 value. In the meantime, the smaller companies have been left for dead. Nobody has wanted to touch them since roughly the end of the Great Financial Crisis when investors started pulling money from small and mid-sized stocks in favor of the large-caps. At the time it made sense because there was systemic risk in the markets with some companies failing and filing for bankruptcy while others were getting bailed out – namely the big ones. Fast forward 15 years and now the large-cap weighting relative to small-caps is at the same level it peaked at in the Dot-com era. However, this does not mean we are headed for a crash, quite the opposite in fact. It looks more likely that we will have advancement and rotation in the market.

If there was ever a time for small companies to outperform it should be now. We are in the midst of a bull market, the short interest on small-caps (those betting against the stocks) is at record highs, and momentum is turning in their favor. Large and mega-cap companies are still advancing, but over the past few weeks they have done so at a slower pace relative to small and mid-cap stocks. In previous instances when investors were narrowly interested in a handful of stocks and positioning is this extreme, a reversion to the mean takes place. This unwind often comes fast and can catch investors off guard. Whether this results in a major shift or a short-term move remains to be seen, but a move of some kind is likely coming. It would actually be abnormal for small-caps to not assume a leadership role before this bull market is over. From studying previous cycles, we see that during almost every major bull-run small-caps lead at some point for a stretch of time.

Looking under the hood we are noticing several sectors with an abundance of small-cap companies posting strong returns lately. To just take one, let’s look at financials. Investors have been largely wary of buying stock in banks since the Financial Crisis of 2008. For one, they were at the heart of the problem with their disastrous loans, and secondly investing in a bank stock is just not as sexy as buying the company that runs all the computers or makes all the phones. But what many are missing, and the market may already be sniffing out, is that banks are among the most underrated AI trades in the market. And US banks aren’t the only ones leveling up in the AI space. The larger banks from around the world are transforming and benefiting as well. Slowly but surely the entire banking industry has reversed the negative trend that was in place for years and have now been outperforming the overall market for months. This is a sector that was dead money for well over a decade but now they are catching bids from investors who view them as innovators in a changing economic landscape. JP Morgan is rolling out its own Chat GPT tool, Bank of America’s AI assistant is handling billions of customer interactions, and Goldman Sachs is using AI to draft IPO documents. As these banks grow their top and bottom lines, they will likely go on buying sprees as well and gobble up financial technology (FinTech) companies and regional banks. This is pushing up valuations in the whole space. And almost all the players are small and medium sized businesses. Banks have enormous amounts of data, billions of customers, and currently a more relaxed regulatory environment. Conditions that are ripe for AI integrations. These factors could combine to make them hyperscale the way we have seen the tech giants do, by investing in data centers and other AI adjacent products, services and technologies.

If small-cap companies are going to take on a leadership role at some point in this bull market, then this could be a sector that plays a significant role.