During the current bull market, there has been a lot of angst about the concentration of gains by a dozen or so stocks within the major indices. Our furry friends in the bear camp remind us that the “breadth” of the market is important and that markets where only a few stocks lead the parade have historically become problematic in the long run.
Having studied markets full time for over 40 years, I can’t really argue the point. I learned a very long time ago that while the trend is indeed your friend, the best bull markets tend to be broad-based, global in scope, and involve more than a few names.
One of the bear camp’s primary complaints about the current joyride to the upside has been that it has been megacap tech leading the way higher. Those seeing the glass as at least half empty point to the disparity between the small cap indices and the large caps, where megacap tech dominates.
To be sure, the disparity has been real and significant. While the NASDAQ 100 Index (using the QQQ ETF as a proxy) has gained +25.9% over the last 12 months (per Morningstar), the Russell 2000 ETF (IWM) is up just +14.9%, with the vast majority of the gain coming in the last few months.
The song remains the same (or worse) when the time frame under review is extended. For example, over the last three years, the QQQ sports an eye-popping annualized return of +30.99% per year versus just +14.72% for the small caps. Ouch.
Fans of broadly diversified portfolios are quick to defend the inclusion of small caps in their holdings, reminding us that money doubles every 4.9 years (using the “rule of 72”) at a +14.72% rate. Not bad, right?
However, tech bulls counter with some math of their own as money can double every 2.3 years using the annualized rate the Q’s have produced over the last three years. Impressive.
The Reason?
One of the key questions investors have had to deal with over the last few years has been, why has this huge disparity existed? Why have the Q’s and megacap tech experienced massive returns while the small caps basically plodded along?
The answer is simple, really as I’m of the mind that there is revolution occurring in computing. Call it AI, if you’d like, but it’s really much more than those large language models that may or may not answer your question correctly. No, from my seat, this revolution is about the massive change occurring in and around computing speed, power and the ability to “think.” As in the demand for speed, smarts, and power in semiconductor chips; the electricity needed to run data centers the size of Manhattan; how to use of all the data available these days; as well as the next big thing in computing (aka Quantum).
My contention is there is an arms race happening in the world of computing. And unlike the bubbliscious days of 2000, this race is occurring between the biggest, best, and most profitable companies on planet earth. In other words, this isn’t about start-ups without revenues and dot.com in their name. No, it’s about the race to “thinking” in computers.
As I’ve mentioned, the big players in this computing revolution don’t need the economy or the Fed to be on their side. They don’t care about the rate of inflation. Or tariffs, geopolitical events, etc. And oh, by the way, the earnings of these companies are growing like weeds.
From my seat, what we are seeing is a generational opportunity in investing. I definitely don’t know which companies will be the leaders of tomorrow. Maybe NVIDIA (NVDA) and Palantir (PLTR) will continue to dominate their respective fields. Maybe not. But one thing I am fairly certain of is there will continue to be outsized opportunities – you just have to understand what is happening and look for the companies leading their industries.
Small Caps Are Catching Up
The good news for diversified investors is the small caps have been catching up lately. And over some shorter periods of time, the IWM ETF has actually outperformed its megacap tech brethren.
Analysts are quick to point to this as a sign that the bull market is broadening out, which, of course, is a good thing from a big picture perspective. Some even go so far as to opine that now is the time for the small caps to shine. You know, since the Fed is cutting rates and the economy is doing just fine. And since the valuations of the tech leaders remain in nosebleed territory, the small cap bulls tell us that investors should be dumping tech and buying cyclicals, value plays, etc.
The Key: Know What You Own!
However, before you run out and sell your tech leaders and buy those small caps, you might want to take a peek at what you are buying inside of the ETFs. I’ve long been a big believer in understanding what you own – especially in today’s ETF world.
So, I decided to dig into the IWM ETF (designed to replicate the Russell 2000 index) to see what was in the portfolio…
According to Morningstar, the number one holding is Credo Technology (CRDO), a company focused on expanding bandwidth barriers whose stock is up +366% over the past year. Next is Bloom Energy (BE), which has surged more than 5X since June. Number three is IonQ, which is a quantum company, up nearly +700% in the last year. Speaking of quantum, Rigetti Computing (RGTI) is also in the top 15 and sports a return of +5,255% in the last 12 months (the stock has tripled since July 15th). And scrolling down a bit further is D-Wave Quantum (QBTS), which has gained +3,456% over the last year.
Looking back at the top 10 holdings, at number six is OKLO Energy (OKLO – a stock we’ve owned for nearly a year), which produces small modular nuclear reactors, is up +1,253% over the past year, and has doubled since early September.
My point(s)? First and foremost, some of the same stuff that is driving the megacap tech arena is also driving the “catch up” performance of the small caps.
Second, many of the names that are atop the list of IWM holdings are no longer “small.” For example, per Yahoo Finance, IonQ has a market cap of $24.8 billion. OKLO’s is $20.1 billion, Rigetti’s is $12.8 billion, D-Wave’s is $11.3 billion… NONE of which still qualify as “small cap” (which, by definition is under $2 billion). And if these companies get bumped from the small cap list, will that “catch up” performance suffer going forward?
Third, these “hot” names are really (as in, REALLY!) hot at the moment – with many doubling and tripling in short periods of time. As such, one needs to expect some pullbacks, which are likely to be rather violent along the way.
And finally, if you think you are buying cyclical and “value” names in the small cap ETF, you may want to think again.
Thought for the Day:
What would life be if we had no courage to attempt anything. -Vincent Van Gogh