The exceptional outperformance of growth stocks within the S&P 500 has emerged as a significant market trend. Over the past two years, the S&P 500 Growth Index has surged by 57.3%, surpassing the overall S&P 500’s 41.6% rise and the S&P Value Index’s 23.8% gain. In the past month alone, the growth index has outpaced value by nearly 9%. Despite this rapid ascent, only 40% of the stocks in the growth index have generated a positive return in the last month. How is this possible?
Before discussing the performance drivers, it is worth noting the definitions of growth and value. According to the S&P Dow Jones methodology, each of the 500 stocks in the S&P 500 is assigned a score for its growth and value characteristics. Companies that score high in sales growth, ratio of earnings change to price, and momentum are categorized as growth stocks. Companies that score well for book value, price-to-earnings ratio, and sales-to-price ratios are put into the value bucket.
Over the last two years, investors have flocked to growth stocks. They bid up the stocks of companies like Microsoft, Nvidia, and Apple because they have consistently grown their revenues and profits at a faster-than-expected pace. These three companies clearly satisfy the definition of growth and have been rewarded with huge gains in their share price and rising valuations. Earnings have accelerated, but their stock prices have shot up even more. Price-to-earnings ratios have moved higher.
With the 2024 rally, the P/E ratio of the S&P 500 Growth Index has expanded to 34.9x, up from 25x at the start of the year. Value stocks are not receiving the same treatment. The P/E of the S&P 500 Value Index has declined so far this year, falling to 18.7x from 20x in January. Investors appear willing to ride the upward price momentum of the growth factor and pay higher and higher valuations in the process. In reality, investors are not blindly betting on growth but on the continued good fortunes of just a few companies.
While many stocks are classified as growth, only a handful of mega-cap stocks are driving the index higher. Over the last month, the S&P 500 Growth Index returned 6.9%, but the average stock had a negative return of 1.6%. The divergence in performance between the average stock and the market-cap-weighted index suggests one of two things: either a group of stocks had extraordinarily high returns, or the largest companies in the index outperformed the smaller ones.
The answer becomes apparent when the index is broken into deciles by market capitalization and returns are analyzed in each group. The largest 10% of companies, with an average market capitalization of over $1 trillion, drove all the returns of the S&P Growth Index.
Only one other market cap decile had positive returns. All other deciles have had negative returns over the last month. Stocks in the first decile, or the smallest 10% of companies in the index, had an average return of -5%. Stocks in the 10th decile, which includes Microsoft, Nvidia and Apple, each worth more than $3 trillion, had an average return of 5.7%. The top ten stocks in the S&P 500 Growth Index have more than a 60% weighting in the index. There are 228 stocks in the index, but just ten companies are responsible for more than half of the return.
Investors have had to deal with the growing concentration levels across all market-cap-weighted indices for the last few years. So far, the dominance of the mega-caps has been good for index investors. Microsoft, Nvidia, and Apple are certainly delivering on lofty revenue and earnings projections. As a result, they keep getting bigger, and the broad indices keep rising.
It’s important not to become complacent in the face of the current market trend. If the AI boom wanes or the economy stalls, the premium investors are willing to pay for the largest growth stocks will likely decrease. Investors should prepare for the potential of higher volatility in the market due to the dominance of mega-cap growth stocks. The few companies leading the market higher today could easily be leading the market lower tomorrow.
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