High Interest Rate Impact Masked by S&P 500

Facing the highest interest rates in decades, why is the US stock market still performing exceptionally well?

The latest market analysis indicates that large-cap technology stocks leading the S&P 500 index, with substantial cash reserves, are not significantly affected by interest rate changes. Moreover, since the S&P 500 index is calculated based on market capitalization weighting, although small and mid-cap stocks impacted by high interest rates are struggling, the overall index remains buoyant.

The market capitalization-weighted S&P 500 index obscures the suffering of small-cap stocks.

Over the past year, technology giants such as Nvidia, Microsoft, Apple, and Google, known as the "Seven Sisters," have led the US stock market higher, catalyzed by the artificial intelligence boom. However, looking back, due to the significant divergence in interest rate sensitivity between large-cap and small-cap stocks, the overall performance of the S&P 500 index and its equal-weighted counterpart can be described as a world of difference—US stocks are not unaffected by the Federal Reserve's monetary policy; it's just that this impact is distorted by the super-weight stocks.

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As of last Friday, the S&P 500 index's year-to-date gain exceeded 10%, while under equal-weight calculations, the gain was less than 5%.

In terms of interest rate sensitivity, the S&P 500 index's movements have a much lower correlation with US Treasury yields than the equal-weighted version, which reflects the average performance of S&P constituents. Currently, the gap between the two is at its highest level since 1999.

Media analysis points out that if the market is divided into ten equal parts by size, as the market value of companies increases, the price-to-earnings ratios of each group also show a relatively steady upward trend. The highest market value technology giants have a forward price-to-earnings ratio of up to 21 times, and the forward price-to-earnings ratio of mid-cap stocks is 18 times, also above historical levels.

The reason is also straightforward: large technology stocks have substantial cash reserves and can lock in low interest rates for debt, or even enjoy the interest income from high interest rates. Small and medium-sized companies lack cash reserves and need to issue bonds, so they are more susceptible to the impact of high interest rates. So far this year, the small-cap Russell 2000 index has only risen by 1.6%, far behind the S&P 500 index.

Investors' concerns about "higher and longer" interest rates make them tend to stay away from smaller market value constituents in the S&P. For example, last Thursday, only 139 constituents of the S&P 500 index fell, with most stocks rising, but the overall market closed down 0.6% due to the drag of large market value weight stocks.

Once interest rate cuts begin, small-cap stocks with valuations at historical lows are expected to catch up.The phenomenon of large-cap and small-cap stocks performing differently is also reflected on a broader level. As previously mentioned in Wall Street Journal articles, the U.S. April PCE (Personal Consumption Expenditure) data indicated that both personal consumption income and personal consumption expenditure saw a decline in their month-on-month growth rates in April. After adjusting for inflation, the actual personal consumption expenditure and actual disposable personal income in April also decreased by 0.1%. Expenditures by consumers on automobiles, dining, and entertainment activities have all been reduced.

Recent data also show that the actual disposable income of U.S. consumers has only slightly increased over the past year, with the savings rate dropping to 3.6%, a 16-month low, which is also significantly lower than the 12-month average of 5.2%. Similar to the stock market, the most vulnerable parts of the U.S. economic sector—poorer American households and young people—have already felt the pressure of high interest rates, with their spending decreasing and dragging down economic growth. This will further be transmitted to mainstream retailers, financial companies, and commodity producers. However, unless the U.S. economy falls into a recession, the profitability of tech giants will essentially remain unaffected.

Nevertheless, the pessimistic economic data also implies that the timing for interest rate cuts is approaching. Looking at the present, the 50 cheapest stocks in the S&P 500 Index have a median forward price-to-earnings ratio of only 15 times, which is roughly consistent with the price-to-earnings ratio of the broad market during the most depressed period of U.S. stocks after the pandemic, making them very cheap.

Analysts predict that once interest rate cuts begin and the pressure from high interest rates eases, small-cap stocks are expected to quickly catch up, matching the gains of large-cap weighted stocks.