The S&P 500 Index and Dow Jones Industrial Average are at all-time highs. The same is true for the NASDAQ 100 Index and many other market averages. But some important averages remain well below their all-time highs.
Small-cap and mid-cap stocks are well below their all-time highs. For example, if we take a look at the S&P 600 – a small-cap benchmark index – we see it ended last week more than 13% below its August 2018 high.
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The mid-cap S&P 400 (below) is almost 5% below its August high.
These indexes demonstrate that the strength in this year's stock market rally has been driven by large-cap stocks. That can easily be explained by the "TINA" thesis; in fact, pension fund managers and other institutional investors have been citing TINA as the reason behind the bull market for some time.
TINA means "there is no alternative" to stocks.
To understand why this can be a problem, it's helpful to consider the goals of pension funds and other major investing institutions.
For pension funds and insurers, the primary goal is having sufficient cash to meet their obligations. They know, with a reasonable degree of accuracy, how much cash will be needed in each of the next 30 years. Their job is to ensure that cash is available. And we're not talking about normal sums of money – these major investors control trillions of dollars in assets.
In the past, this might have been done with a mix of stocks and bonds; let's say half the portfolio in bonds and the other half in stocks. (I'm simplifying here for the sake of the example.) If the manager had $100 billion in assets, $50 billion in bonds might have generated $4 billion in income at 8%. That might have covered almost all of their payouts for the year.
It's important to remember 8% was a reasonable goal for fixed-income investors just a few years ago. Investment-grade corporate bonds yielded at least 7.5% prior to 2002.
Source: Federal Reserve
An investment manager could add a small amount of junk bonds to the portfolio and achieve 8%. Depending on how much cash was needed, it might be possible that bonds could meet the fund's objectives and the rest of the money could be invested for growth.
But that was 20 years ago. Today, the problem is different. Managers still need to generate cash, but investment-grade bonds yield less than 5%.
Junk bonds will boost that yield but risks in that sector tend to be uneven. There will be more defaults during a recession, and the risk-management models will limit the amount of exposure to the sector based on the company's worst-case scenario.
To generate the type of returns the pension fund or insurer needs, the manager will need to reduce the amount of bonds to the lowest possible level and invest the rest in stocks. The reason, again, is TINA – there is no alternative asset that can deliver the returns they need.
Proof of the TINA market can be found in the fact that large-cap stocks are enjoying the largest gains in the bull market.
Historically, smaller stocks have delivered the largest gains. This is shown in the chart below where mid-cap stocks (yellow line) and small caps (red line) have significantly outperformed large caps (green line).
In the chart, I used the S&P 600 to show small caps, the S&P 400 for mid-cap stocks, and the S&P 500 for the large-cap index.
The next chart shows just the past five years.
This is the time period when the problem facing pensions and insurers has become apparent in the market. After more than a decade of low yields on bonds, the managers were forced to change the way they invested.
The result of their changing behaviors is demonstrated by the relative strength of large caps. Large caps have been stronger than smaller stocks in the past five years, at least in part, because large funds are buying more stocks.
A manager with $100 billion in assets will need to invest a large amount of money. One definition of a mid-cap stock is a company with a market cap of less than $10 billion. Let's say the manager buys 9% of the stock.
Fund managers will often face a limit on the amount of a single stock they can own. If they own more than 10%, the manager will have to report that holding to the SEC. Many managers prefer to limit the amount of reporting they do so they may keep their ownership stake under 10%. That's why I selected the 9% position for this example.
A 9% position in a stock worth approximately $10 billion would be worth $900 million, or 0.9% of the entire $100 billion investment fund. In a bull market, if the stock gains 20%, the fund's value increase by 0.18%. In other words, a great small stock will be insignificant to a $100 billion fund.
The fund manager will have to do a lot of work to find enough smaller stocks to have an impact on their performance. For that reason, they tend to look to large caps.
With the Federal Reserve likely to lower rates, the pension funds and insurance companies will continue to face this problem for at least a few more years. They will most likely continue to need to generate returns without depending on bonds to provide significant income.
That means we should continue to see gains in large-cap indexes outpacing small-cap indexes. However, that doesn't mean there won't be any opportunities in small caps – just that stock selection will be even more important than usual.
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