Why the Stock Market Has Risen Even With No Fed Rate Cuts

The Federal Reserve has disappointed investors this year, but no matter. The markets have adjusted.

Even without any interest rate cuts so far in 2024 — and with the likelihood of just one meager rate reduction by the end of the year — the stock market has been purring along. That’s quite an achievement, given the expectation in January that the Fed would trim rates six or seven times in 2024 — and that interest rates throughout the economy would be much lower by now.

Buoyant as the stock market may seem, when you look closely, it’s apparent that the S&P 500’s recent returns rest on a precarious base.

A.I. fever — based on the belief that artificial intelligence is ushering in a new technological age — has been spreading among investors, and that has been enough so far to keep the overall stock market averages rising. But the rest of the market has been rather ho-hum. In fact, strip away the biggest companies, especially the tech companies, and overall market performance is unimpressive.

Concentrated Returns

One stock in particular has led the market upward: Nvidia, which makes the chips and other associated infrastructure behind the talking, image-generating, software-writing A.I. apps that have captured the popular imagination. Over the last 12 months, Nvidia’s shares have soared more than 200 percent, vaulting its total market value above $3 trillion, which places it in elite territory shared only with Microsoft and Apple in the U.S. market.

Other giant companies with a convincing A.I. flavor, like Meta (the holding company for Facebook and Instagram) and Alphabet (which owns Google), along with chip and hardware companies like Super Micro Computer and Micron Technology, have turned in superlative performances lately, too.

But the narrowness of the stock market rally becomes clear when you compare the standard S&P 500 stock index with a version that contains the same stocks but is less top-heavy.

First, consider that the standard S&P 500 is what is known as a capitalization-weighted index — meaning $3 trillion stocks like Microsoft, Apple and Nvidia have the greatest weight. So when these giants rise 10 percent, say, they pull up the entire index much more than a 10 percent gain by a smaller company in the index, like News Corp, with a market cap of around $16 billion, can.

The standard cap-weighted S&P 500 has risen almost 14 percent this year — a spectacular gain in less than six months. But there is an equal-weighted version of the S&P 500, too, in which 10 percent gains — for giants like Microsoft and merely large companies like News Corp — have the same effect. The equal-weighted S&P 500 has gained only about 4 percent this year. Similarly, the Dow Jones industrial average, which isn’t cap-weighted (it has plenty of its own idiosyncrasies, which I won’t get into here), is up only about 3 percent.

A Premium on Size

In short, bigger is better in the stock market these days. A recent study by Bespoke Investment Group, an independent financial market research firm, demonstrates this. Bespoke broke down the S&P 500 into 10 groups, based solely on market cap. It found that the group containing the biggest companies was the only one to have positive returns over the 12 months through June 7. At the same time, the group with the smallest stocks in the index had the biggest losses.

This pattern held true when Bespoke looked only at A.I. companies. Giants like Nvidia had the strongest returns. Smaller companies generally lagged behind.

During just this calendar year, stock indexes tracking the largest companies are trouncing those that follow small-cap stocks: The S&P 100, which contains the biggest stocks in the S&P 500, is up about 17 percent. The Russell 2000, which tracks the small-cap universe, is up about 1.5 percent for the year.

Even among technology stocks, the bull market isn’t treating all companies equally. Ned Davis Research, another financial market research firm, said in a report on Thursday that while companies that design, manufacture or make equipment for chips (a.k.a. semiconductors) in the S&P 500 are performing splendidly, all other technology sectors have lagged the index this year.

Implications for Investors

While I pay close attention to these developments, I try not to care about them as an investor. In fact, I view the concentration of the current market as a vindication of my long-term strategy, which is to use low-cost, broadly diversified index funds to hold a piece of the entire stock and bond markets. The overall market’s dependence on a small cohort of big companies is fine with me, but that’s only because I’m well diversified. So I don’t worry much about which part of the market is strong and which isn’t.

As far as my own portfolio is concerned, I’m not terribly anxious about the problems that inflation and high interest rates are causing in the bond market, either.

Note that bond interest rates are set by traders who have reacted to the Fed’s tight monetary policy and stubborn inflation this year by bidding longer-term interest rates higher — not lower, as had been widely anticipated.

Higher rates are a problem because when bond yields (or rates) rise, their prices fall, as a matter of basic bond math. Bond mutual fund returns are a combination of income and price changes. While higher yields generate more income, they hurt bond prices. Many investment-grade mutual funds are treading water this year, as is their main benchmark, the Bloomberg Aggregate Bond Index.

My own funds track that index. I’m not making any real money from my bond funds, and haven’t for several years. But they usually provide ballast and stability in my portfolio. I’m not delighted by what’s been happening to bonds, but I can live with it.

On the other hand, if you’re an active investor who makes bets on individual asset classes, stocks or sectors, there’s a lot to think about right now. You may bet on the continuing momentum of the biggest stocks — or even of just one, Nvidia. Of course, you may believe it’s smarter to go the other way entirely. You may want to seek stocks that have been neglected in this narrow bull market — stocks with lower market capitalizations and what seems to be greater value, based on metrics like their price-to-earnings ratio.

Historically, small-cap value stocks have outperformed large-cap growth stocks over long periods, though they haven’t done so recently. Maybe it’s time for a turnaround? While you’re making changes in your investments, you may also conclude that bonds and bond funds are a waste of time, compared with the stock market and its more spectacular gains.

Make the right decisions on any or all of these issues and you could make a great deal of money. Some people undoubtedly will. But if you make a mistake now — or later, even after making some blazingly lucrative bets — you could easily end up losing most of your money.

What the Fed does next will matter a great deal, too, if you’re inclined to make active bets on the market. Persistent inflation convinced policymakers this past week that they needed to hold the federal funds rate at about 5.3 percent — high enough, in the central bank’s estimation, to gradually bring inflation down further. There has been a little good news on that front, with producer prices dropping and the Consumer Price Index falling slightly in May, to a 3.3 percent annual rate, down from 3.4 percent — but too high for the Fed’s comfort.

The futures market predicts that at the Fed’s July meeting, which falls right between the Republican and the Democratic conventions, it will keep rates where they are. But most traders are betting that the Fed will cut rates in September. That could set off a broader rally in the stock market, and one for bonds, too. With national elections in November, a Fed cut in September would undoubtedly delight President Biden and, I suspect, displease former President Donald J. Trump, who has been known to express his feelings vociferously.

There’s a lot to think about, so much that it’s impossible to know in advance what the best short-term moves are.

So I’m playing the long-term percentages, based on plenty of academic research suggesting that most people, most of the time, are better off letting the overall markets make their money for them. Keep costs low with index funds; hold stocks and bonds all the time, in a reasonable proportion for your needs and risk tolerance; and try not to worry too much about all of these complex issues — not in your investing life, anyway.

I don’t know what the Fed will do next, and while I do care, I won’t let it sway me financially. The bond market has been weak. The stock market isn’t entirely stable, but that’s all right, too. I expect that there will be some painful losses ahead, but greater gains for those who simply stay the course.