Mid-Year Review
A closer look at domestic equities, however, shows a narrow subset of stocks continuing to lead and lower – even negative – returns across the broader market. Currently, the US market is dominated by a few very large stocks: six companies comprise nearly one-third of the S&P 500 Index, a common market proxy.4 Outside of the S&P 500’s mostly large, growing companies, stock prices fell. Small companies lost about 3.25% and value (low-price) companies dipped just over 2%.5
We typically recommend a mix of large and small, growth and value, US and international stocks. Last quarter, our diversified approach likely led to lower returns for clients compared to the broad, growth-oriented indices. Thus, today we’d like to review why small and value companies went down last quarter, review the historical returns of large and growth stocks versus small and value, and explain why we believe diversification remains prudent for long-term investors.
Why Did Small and Value Stocks Go Down in Q2?
Small and value companies dropped last quarter largely due to inflation fears and frustrated hopes for interest-rate cuts. You may recall that, from March 2022 to January 2024, the Federal Reserve raised interest rates 11 times to help control inflation as the US economy entered its post-COVID stage.6
By the end of March, as the chart below shows, inflation dropped significantly and appeared headed toward (or below) the Fed’s target of 2%. This “disinflation” led most analysts to expect three interest-rate cuts in 2024. During the second quarter, however, inflation did not come down as the market expected. Stickier inflation led analysts to revise their expectations to one rate cut before the end of the year. Because expectations are baked into stock prices, moving from three expected cuts to one had the practical impact of raising rates.
To simplify, interest rates help determine the borrowing costs for companies. Small and value companies tend to have higher borrowing needs.7 Fewer interest-rate cuts this year means higher costs for small and value. Other things equal, higher costs lead to lower stock prices and, last quarter, negative stock returns.
A Few Stocks Continue to Drive the Market
As we discussed last quarter, a few very large tech companies comprise an increasing share of the market returns.8 This phenomenon continued as current Wall-Street darling Nvidia accounted for more than 40% of the S&P 500 Index return last quarter.9
Why Do We Recommend Owning Small and Value Companies?
Risk and return are related. Over time, riskier assets have higher expected returns. As investors, we understand that owning bonds carries more risk than holding cash. Because of that risk, bonds have higher expected returns than cash. Moreover, owning stocks entails more risk than owning bonds. Stocks, thus, have higher expected returns than either bonds or cash.
The relationship between risk and return persists within asset classes as well. Small and value companies tend to have more risk than large, growing companies. Because the risks are higher, small and value investors demand a higher expected return. Over long periods of time, small and value stocks have provided investors higher returns than large-growth stocks: Since July 1926, the S&P 500 has returned 10.4%, annualized.10 Over the same period, small-value stocks have returned 14.2%, annualized.11 That’s a large difference! We believe stocks represent the growth engine in our portfolios. Owning small and value stocks can turbocharge that engine.
How Long is the Long Term?
“Expected returns” are not the same as actual returns. As noted above, we know that holding cash means less risk than holding bonds or stocks. But that doesn’t mean that each year, every year, bonds and stocks will “beat” cash. We need only look at 2022 when most investors earned a few percent interest on their cash, while major stock and bond indices went down double digits.
So how long must investors wait? It could be a long time. The chart below shows the total return of large-growth stocks and small-value stocks, represented by the S&P 500 Index and the Russell 2000 Value Index, respectively, since 1990:
We chose this time period for two reasons. First, we believe 35 years roughly represents an investment lifetime: many of our clients engage us when they are 10-15 years from retirement and planning for a retirement lasting 20-25 years. Second, we wanted to include the 1990s bull market because most investors and analysts view the 90s as a golden age for growth and tech stocks, quite like today’s market.
As the chart shows, over the last 35 years, the S&P 500 did provide higher returns than the Russell 2000 Value. Given these results, we’re not surprised investors have questions regarding whether it makes sense to own small and value stocks.
We believe the ending value alone is not dispositive. We don’t invest our money, go to sleep for 35 years, and then wake up and check the balance. We earn, save, invest, and spend along the way. Let’s take a closer look at return differences over that time.
First, we’ll examine the 1990s. Many investors and analysts remember that decade as the heyday for the S&P 500 and growth stocks generally. But was it?
The above chart shows small-value companies led large-growth companies for much of the decade. At the start of 1998, in fact, small-value companies provided a total return of 251% for the decade, edging out the S&P 500 cumulative return of 244%.
In 1998, however, we can see a sharp downward move for the Russell 2000 Value while the S&P 500 continued its rapid climb. Thus, we believe it’s not correct to say “the 90s” were good for the S&P 500. Instead, we believe it’s fair to say the S&P 500 had a remarkable two-year run that capped a decade of solid growth across the US markets. The last two years of the 90s are what many analysts and investors now refer to as the “tech bubble.” Unfortunately, we all know what happens to bubbles, as the next chart shows:
The chart above shows the returns from large-growth and small-value companies in the 2000s. Not surprisingly, this is now known as the “Lost Decade” for the S&P 500. The S&P 500 had negative annual returns for a decade. If you invested $1M in the S&P 500 at the start of the 2000s, you ended up with about $910K after 10 years. Small-value companies, on the other hand, more than doubled during that time.
Let’s now look at the next decade, the 2010s:
To our eye, this chart echoes the chart from the 1990s: the two equity groups had very similar returns for most of the decade. But beginning in 2017, the S&P 500 took off compared to the Russell 2000 Value. Once again, we don’t believe it’s correct to say the S&P 500 dominated the decade but, rather, capped the decade with a remarkable three-year run.
The end of the 2010s brings us to a point just before COVID-19 began to spread across the globe. It’s hard to believe we’re more than four years past, but in 2020 you may recall that major parts of the global economy shut down. Some large tech stocks, however, thrived as many of us stayed at home looking at our Apple phones, watching Netflix, and working together via Zoom and WebEx.
If we take the last three years of the 2010s and extend that a year to include the pre-vaccine COIVD era, we see an explosion for the S&P 500:
The chart shows a 60% return difference between large-growth and small-value stocks over a mere four-year period. That’s not unprecented, but it’s highly unusual. Once the government and pharmaceutical companies announced that vaccines were on the way, and investors coud see the proverbial light at the end of the COVID tunnel, large and growth ceased to dominate.
The chart below shows the next two years, 2021 and 2022, the time from which COVID vaccines came to pass through the bear market of 2022.
Finally, the chart below shows the most recent 18-month period, during which Nvidia has been essentially carrying the market:
Let’s now go back and examine the “big picture:” has the S&P 500 “beaten” the Russell 2000 Value index over the trailing 35 years? Or has the Russell 2000 Value provided higher returns than the S&P 500 for most of the last 35 years, excepting a four-year run culminating in a once-in-a-lifetime economic shock followed by an 18-month explosion by one large tech company?
The answer matters because we can’t invest in the past. If we believe risk and return are no longer related, i.e., that large healthy companies are likely to have higher returns than small-value companies, then we might decide to own the S&P 500 stocks exclusively. If we believe that risk and return remain related, and that we don’t know what the next 10 or 20 or 35 years will bring, we’re likely to remain diversified with a mix of large and small, growth and value.
What if We’re Wrong?
Individual investors often focus on the upside: what might the gains be if we guess correctly? We understand the impulse: it’s exciting to think about blockbuster returns, and perhaps owning a larger home or retiring earlier. As financial-life advisors, however, we take a different approach. Most of our clients, typically through a combination of hard work and savings, already find themselves with substantial financial assets. We view our job as helping our clients define what wealth means to them, aligning their financial assets with their values, and helping them along the way as they build wealthier lives.
We are, thus, very concerned with the downside of our investment decisions. Asking “what if we’re wrong” helps us identify potential pitfalls that can turn a confident financial plan and a comfortable retirement into economic anxiety.
An Historical Example
The 2010s growth run reminds us very much of the 1990s: a decade-plus bull market capped by explosive returns for growth companies. Not surprisingly, in the late 90s many investors felt comfortable retiring – and retiring early – believing they could rely on double-digit growth-stock returns for the foreseeable future.
Let’s examine what might have happened if someone chose to retire after the 1990s growth run and just before the “Lost Decade.” Assume two hypothetical clients retired at the end of 1999. Both clients had a $1M portfolio with 60% equity and 40% bonds.12 Each year, both clients withdrew $40K (4% of their starting portfolio value) and rebalanced to 60/40. The only difference: Client 1 had an equity portfolio consisting only of large US companies. Client 2’s equity portfolio had half US large and half US small-value.13
At the end of the decade, the two portfolios looked like this:
Even with 40% bonds, Client 1’s portfolio ended the decade down more than 25% after all withdrawals. If we include inflation, Client 1 lost more than half of their purchasing power in the first 10 years of retirement. Client 2 fared better. After all withdrawals, the diversified portfolio rose nearly 10% in value. Adjusting for inflation, Client 2 still lost some purchasing power, about 18%.14
Clearly, no one wants to lose purchasing power early in their retirement. But in our hypothetical, Client 1 ended up in a very difficult situation. By “guessing wrong,” Client 1 compromised their retirement and likely faced a radical change in spending, returning to work, or both.
Client 2 also lost some purchasing power; diversification doesn’t guarantee success. But the more diversified portfolio reduced the impact by nearly two-thirds. Client 2, thus, found themselves in a relatively strong position. They likely could maintain their retirement-plan confidence by reducing some discretionary spending.
Why do We Invest?
We believe our financial portfolio should help us meet our long-term goals. We understand how easy it is to let the recent past influence our expectations for the future. The history of financial markets, however, shows how unpredictable the future can be. We don’t know whether the next 10 years will look like the previous 10. That’s why we continue to recommend diversification: we believe it’s the best way to help preserve and grow our financial wealth. When building a wealthier life, we don’t want a “Lost Decade” to be your last decade.
[1] Global stocks represented by the MSCI ACWI Index. All investment returns from Morningstar unless otherwise noted. Past performance is no guarantee of future results.
[2] US Stocks represented by the S&P 500 Index. Developed-markets stocks represented by the MSCI EAFE Index (net).
[3] Emerging-markets stocks represented by the MSCI Emerging Markets Index (net).
[4] Source: iShares Core S&P 500 ETF holdings, iShares, 7/16/2024.
[5] Small stocks represented by the Russell 2000; value stocks by the Russell 1000 Value Index.
[6] A timeline of the Fed’s ’22-’23 rate hikes & what caused them, Rodini, TheSteet.com, April 12, 2024.
[7] See, e.g., How do changing interest rates affect the stock market?, US Bank.com, June 18, 2024.
[8] The Magnificent One, Wealth Architects, April 2024.
[9] Source: Morinngstar.com; As of 3/31/2024 Nvidia represented 5% of the S&P 500 Index; NVDA stock rose nearly 37% in the quarter.
[10] Source: DFA Returns Web and Wealth Architects.
[11] Ibid, using F/F US Small Value Research Index.
[12] Bonds represented by the Bloomberg Aggregate US Bond Market Index.
[13] All hypothetical figures and results are from portfoliovisualzier.com. For the hypotheticals we used the same asset classes in the charts above. We also ran a scenario using additional asset classes more in line with the portfolios we typically recommend to clients (e.g., foreign stocks and real estate). The hypothetical ending values were higher than both scenarios presented here.
[14] Source: portfoliovisualizer.com and Wealth Architects. The inflation-adjusted annualized return (CAGR) was -5.55% for hypothetical portfolio 1 and -1.71% for hypothetical portfolio 2.
Copyright © 2024 Wealth Architects, LLC
The S&P 500 Total Return Index (“S&P 500”) is an index of 500 stocks chosen for market size, liquidity, and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. Companies included in the index are comprised exclusively of large cap equities, primarily domestic issuers. The S&P 500 is a market value weighted index with each stocks’ weight in the index proportionate to its market value. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000® Index and represents approximately 10% of the total market capitalization of that index. It includes 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 Index is constructed to provide a comprehensive and unbiased small-cap barometer.
The Russell 2000 Index and the S&P 500 Total Return Index (together the “Indices”) include the reinvestment of dividends, but do not reflect the deduction of advisory fees, brokerage commissions and/or transaction fees, taxes or other expenses of investing. Furthermore, the Indices are unmanaged and are not available for direct investment. The Indices are presented for the sole purpose of demonstrating the effect of material market and/or economic conditions on the Fund’s portfolio during the performance periods presented. In comparison to the Indices, the Fund: represents the returns of a long/short portfolio whereas the Index is long only; may utilize other forms of leverage, such as margin, which the Index may not utilize; is substantially less diversified in terms of its holdings; has lower volatility; and will generally have lower liquidity.
The information provided in this commentary is intended to be informative and not intended to be advice relative to any investment or portfolio offered through Wealth Architects. The views expressed in this commentary reflect the opinion of the author based on data available as of the date this article [essay] was written and is subject to change without notice. This commentary is not a complete analysis of any sector, industry or security. Individual investors should consult with their financial advisor before implementing changes in their portfolio based on opinions expressed. The information provided in this commentary is not a solicitation for the investment management or other services offered by Wealth Architects. References incorporated into the report [essay] from third party sources are as of the date specified and are believed to be reliable. Wealth Architects is not responsible for errors in the third party data.
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