State of the Market
Global equity markets are about three years removed from their low point in 2022 that was a function of rapidly increasing inflation and interest rates. Since then, the leaders of the market upswing need no introduction, they are very well known collectively as the Magnificent 71 (Mag 7) or, more broadly, the artificial intelligence beneficiaries.
Perhaps less well-known, however, is the more recent dynamics underpinning the markets that, as we will illustrate, appear to heavily favor lower quality securities. Some might even say “junky.”
First, something we like to use as a simple ‘quality proxy’ focuses on the US Small Cap landscape. There are two widely followed providers in the US Small Cap space, Russell 2000 and S&P 600, but they occasionally produce drastically different results. The Russell 2000 is a group of approximately the 2,000 smallest US companies, with size being the only real requirement for inclusion. The S&P 600, however, applies a few constraints, most important of which is a profitability requirement. In other words, given the ‘profitability’ requirement, the S&P 600 is often considered a higher quality security set. In fact, per the latest Q3 JPMorgan Guide to the Markets,2 46% of the securities in the Russell 2000 were unprofitable, highlighting the different makeup between the two.
Chart 1 highlights what has occurred over the past 6 months between these two US Small Cap offerings, to which the performance of the Russell 2000 (IWM ETF) has outperformed the S&P 600 (IJR ETF) by one of the widest margins in a 25-year history. As a ‘quality check,’ this extreme outperformance would suggest to us that the market is being driven by lower quality companies.
We wanted to take this one step further and zoom in on the ‘least profitable’ segment of US Small Caps. We just stated that 46% of the Russell 2000 is unprofitable. If the unprofitable Russell 2000 is outperforming the profitable S&P 600 by one of the largest amounts on record, then can we isolate if it is truly the least profitable names that are in control?
Goldman Sachs has produced an index that consists of the least profitable Small Caps vs. sector peers (excluding Energy and Commodity sectors) that helps us illustrate this. In Chart 2, we narrow the time frame but still exhibit that the least profitable small cap companies are outperforming the Russell 2000, which we already know is 46% unprofitable.
So, we have rankings as follows: Least Profitable Small Caps > unprofitable (46%) Russell 2000 > profitable S&P 600. Put another way – low quality companies, as determined by profitability measures, are outperforming in this market environment.
Finally, we’ll expand this view to look broader, beyond just US Small Caps. Everyone is familiar with the S&P 500, and as we pointed out at the onset, aware of the big drivers since the 2022 market lows (Mag 7 / AI beneficiaries). The S&P 500 has continued to perform well, especially after the volatile period surrounding “Liberation Day” and the tariff turmoil.
Despite this, there are a couple of interesting groups that we think fall in-line with much of the commentary already provided above. Chart 3 compares the S&P 500 with a basket of Unprofitable Tech stocks and a basket of the Most Shorted stocks on both a YTD and “since market bottom” horizon.
- Unprofitable Tech falls along the same purview we saw in Small Caps – that being in which the companies lacking profits are ripping higher.
- Most Shorted stocks – which is a basket of 70 of the most shorted securities – are most often associated with ‘smart money,’ such as Hedge Funds, who are trying to profit from a stock declining in price. There is usually a reason why companies are shorted, the primary one being the belief that a company is well overvalued relative to its fundamentals. But even this group has seen a substantial move higher this year.
We know the market will go through phases where enthusiasm reaches extreme levels. These charts are indicative of an underlying theme taking hold of the market, especially over the past six months. Quality (or profitability) is an important variable to consider as long-term investors. While “junk” may have its occasional day in the sun, it has historically not worked out well over long periods.
Owning equities is an important aspect of everyone’s portfolio construction. It allows investors to participate in the future growth of a business, but, for a business to have sustainable growth, they at some point need to be capable of generating profits and funding their company from within (via cash flows) rather than being reliant on debt and equity issuance. There are plenty of stocks fully capable of doing this, but for now, some of the biggest drivers of the market appear to be on the opposite end of the spectrum.
