The Gap Between Mega Cap Stocks and the Rest of the U.S. Equity Market

  • Economy and capital markets
  • 6/22/2020
The Gap Between Mega Cap Stocks and the Rest of the U.S. Equity Market

Investors search for answers as a gap grows between mega caps and other U.S. equities. Here are thoughts behind the divide and potential market scenarios for the months ahead.

Key insights

  • Right now, mega caps are the driving force behind the U.S. stock market, making up 20% of the S&P 500. (Source: Investopedia)
  • Mega caps prop up the market, but could create a widening gap among the rest of the U.S. equities market.
  • Mega caps that contribute to the recovery effort may be positioned to weather the pandemic.
  • While a U-shaped or V-shaped recovery might be on the horizon, there is also a middle path.

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Recently, there has been talk about the resiliency of U.S. equities and the contrast with the bleak outlook in the U.S. labor market. However, not all equities are the same. Mega cap stocks — large companies that typically have a market capitalization over $200 billion — lead the way. Now, there’s a chasm between the big tech names and the rest of the U.S. equities market.

What can we make of this growing gap? Behemoths like Microsoft, Google, Amazon, and Apple collectively make up nearly 20% of the S&P 500. These mega-caps have continually outperformed while other equities have been left behind. (Source: Investopedia)

What is causing the gap?

The markets distinguish between companies they think are part of the solution (such as tech and biotech) and companies that are most vulnerable (like travel and hospitality). We’re seeing this not only in the day-to-day trading activity but in the inflows of cash into these mega cap stocks over the last few months. Right now, investors want to understand which parts of the economy are most vulnerable, which parts came into this crisis in a position of strength, and which have the potential leave in a position of strength.

There are several other factors that could impact the gap

With more Americans working from home, people are using collaborative tools day in and day out. The mega cap companies that are able to leverage a remote work environment have a leg up over others.

Additionally, the government and the Federal Reserve (the Fed) have taken decisive legislative and policy actions. These actions include:

  • Cutting the Fed Funds rate to zero
  • Making securities purchases (QE)
  • Offering multiple lending programs designed to assist corporate and small businesses
  • Extending direct lending to municipalities
  • Backstopping money market mutual funds
  • Vastly expanding Repo Operations
  • Temporarily relaxing banking regulatory requirements

The Fed still has room to expand its lending facilities. The Treasury initially pledged $50 billion from its Exchange Stabilization Fund to protect the Fed from losses. The $2.2 trillion CARES Act provided Treasury with an additional $454 billion that can be used to backstop the Fed’s programs. The new and expanded programs announced April 9 used $185 billion of that. So it’s not just market forces at work — their decisions have benefited certain sectors of the economy far more than others.

There is also debate as to what the “new normal” looks like. Instead of making bets on individual companies, you may overweigh specific sectors or invest in thematic exchange-traded funds (ETFs) to round out your portfolio.

Keep in mind, there are still many unknowns. As phased plans bring people back to work, there is still talk about a second wave, questions about a vaccine, and differing conditions on a state-by-state basis.

As the country collectively tries to go back to work, people tend to fall in one of three broad categories: parents who can’t return to work because they have young children at home and no school or daycare options; those who won’t go back to work because of some underlying condition or concerns about contracting the virus; and those who can’t wait to go back to work.

Just as people across the country are reacting differently to the return to work, so too could the markets.

What are the potential market scenarios?

The most important implications of COVID-19 are, of course, the human implications and how it has changed how we live. It is important to acknowledge this as investors consider various potential scenarios on how the market might react in the months ahead. All of these scenarios assume we have already fallen into a recession:

  • A U-shaped recovery — Social distancing continues. The economy cannot meaningfully recover before the widespread distribution of a vaccine.
  • A V-shaped recovery — We experience lower infection rates and more effective treatments, and the economy embarks on a more meaningful recovery later this year.
  • The middle path — The economy takes tentative steps toward recovery later this year as social distancing requirements are relaxed, but then surges in 2021 once a vaccine is available.

In all of these scenarios, the economy should be stronger by 2022. And it’s quite possible that mega caps lead this road to recovery, which justifies the resiliency seen in the stock market today

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