How to Win in a “Winner Take All” Market

By TradeSmith Research Team

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Let’s face it. It’s been a challenging bull market the past year.

The new uptrend that began last October has been incredibly narrow. So while the broad market is up 20% from a year ago, just a handful of stocks are holding up in this difficult tape. Most stocks are sputtering.

There’s a big reason why equities are under pressure. The Federal Reserve embarked on a rate hiking spree that took the Fed Funds rate up 525 basis points in only 18 months.

As interest rates rise, the cost of capital surges. This new reality has hit many core areas of the market — housing, automobiles, and more.

However, one group of stocks have been navigating the changing macro landscape in stride: Mega-cap Tech and Big Oil.

There’s a reason for the outperformance… and reason to believe these chosen few will keep dominating over the medium-term. I’ll share what that reason is — and how you can screen for companies that hold this rare quality — today.

But first, let’s size up the true character of the market since the bear market low.

The Winner-Take-All Market

If you own a diversified basket of stocks, you know there’s a huge divergence in returns the past year.

We’re sitting right at the 1-year anniversary from the bear market low on October 12, 2022. Since then, the S&P 500 (SPY ETF) has gained 20%. Not bad!

But when you peel back the onion, you’ll notice that all isn’t healthy under the surface.

Much of that strong performance is due to the largest stocks in the index… and not much else.

The chart below reveals this underwhelming truth…

Source: FactSet, TradeSmith

Since the bear market low, the average stock in the S&P 500 is drastically underperforming the index, posting a meager 8.94% return.

This is represented by the S&P 500 equal-weight ETF (RSP, in pink). These modest gains are in stark contrast to the 50 largest stocks in the S&P 500 (XLG, blue, at the top), which are displaying gains of 28.25%.

When you single out the smallest companies in the U.S., the Russell 2000 (IWM, blue, bottom) is nearly flat with a 1.09% performance.

All stocks are not equal, to say the least!

But here’s the deal. Betting on the biggest U.S. companies has been a winning recipe for years. As I told you months ago, the number of superstar stocks is shrinking.

From 1926-2022, just 72 stocks account for half of the market’s wealth creation!

It’s a winner-take-all market. And you can see this dispersion the past 10 years.

Since 2013, the mega-cap S&P 50 has outperformed the S&P 500 by nearly 40%. Returns of 229% vs. 189%.

Compared to the equal-weight S&P 500, the reality is stark. Mega-caps enjoy an outperformance of nearly 90%.

Source: FactSet, TradeSmith

The logical question becomes, why are the largest companies drastically outperforming?

Much of it has to do with the quality of their businesses. After all, we’re talking about the likes of Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), NVIDIA (NVDA), and others.

These well-run firms have incredible products and services. Many of us rely on iPhones, Office software, and Amazon delivery services in our daily lives… not to mention the semiconductors that power all these things!

This has led to some enviable fundamentals. The average 10Y sales CAGR (compound annual growth rate) for these four companies is +16.05%. The average 10Y net income CAGR is +24.35%!

With fundamentals like that, it’s no wonder they’ve crushed indexes for years!

But that was then — when rates were low, the world was largely peaceful, and stocks were decidedly bullish. What about now?

Turns out, the current murky macro environment is benefitting many of the largest firms.

That’s because, as interest rates have soared, the net interest earned on cash balances has ballooned.

While higher rates choke off growth for smaller, uncapitalized firms, it has a stimulative effect on cash-rich enterprises.

Consider this: Nearly a dozen large tech and oil companies are resting on $542B in cash. That represents a huge income generator.

That equates to nearly 30 billion in net interest earnings the next 12 months assuming a 5.5% standstill yield.

Meet the cash kings:

As high rates act as headwinds for most, it’s a net tailwind for these equity stalwarts. This is why I believe these historical winners can offer ballast to portfolios during trying times… like now.

Right now, you want to focus on companies holding large cash moats. The risk-free yield in short-term Treasurys isn’t just for the little guys… it’s just as beneficial for the big boys!

That said, plenty of stocks are being sold indiscriminately right now.

As I told you last week, small caps are not only lagging by historical proportions, they offer some of the most compelling valuations seen in recent history.

Yes, bet on big tech, but also consider nibbling in the oversold small-cap pasture too. These relative underperformers will eventually have their day again.

Which is why data needs to be part of your investing process. TradeSmith offers a data-focused lens to size up market internals.

Once the wave of money flows back towards prior leading stocks, you’ll want to be positioned for profit.


Lucas Downey,
Contributing Editor, TradeSmith Daily