April was a good month for most mainstream asset classes, but challenging for diversifiers like Small Cap Stocks and Emerging Markets Stocks.
The multi-year trend for Large Cap Stocks to outperform Small Cap Stocks continued in April. Large Cap Stocks were up 1.6% while Small Cap Stocks were down 1.8%. A portion of this divergence in returns can be attributed to the historical tendency for larger companies to hold up better than smaller companies during recessions. Many economists and investors have become increasingly convinced that a recession may happen soon. Another reason for Small and Mid Caps’ lagging performance is that many of the maligned regional banks that have been in the press recently are constituents in smaller company indexes. If stock prices for smaller companies lag much more, they may start to present an attractive opportunity to overweight Small Cap Stocks, but we want to wait for a larger margin of safety before we shift allocations.
The largest 15 companies in the U.S. currently account for roughly 33% of the capitalization of the S&P 500 index. Reviewing the details for their financial results can often provide a good proxy for the overall market. The table below shows the quarterly Earnings-Per-Share (EPS) for these companies. Apple and Berkshire have not yet reported quarterly earnings when this report was written. The quarterly numbers bounce around and it is hard to identify broad trends, but those of us who enjoyed algebra and remember the formula y = mx + b will recall that m represents the slope of a line. I like to review the slope of the earnings growth for firms as a quick, smoothed out point estimate for the direction of earnings growth. The third column in the table below has the slope for EPS growth for the largest 15 corporations in the U.S. for the last eight quarters. A positive slope indicates earnings have been growing, while a negative number (in red below) shows shrinkage.
The values in the table above are concerning, particularly during a period of high inflation. Over the mid- and long-run, stocks are typically a good hedge against inflation and we want to see earnings growth at least keeping up with inflation. However, the average slope for these stocks’ EPS over the last two years is -0.10. It is often the case that inflation hits expenses for companies before it passes to revenues, and we might expect a temporary dip in earnings will be corrected during the next few quarters, as companies pass on higher prices to consumers.
If upcoming US federal debt ceiling negotiations result in lower spending or higher taxes, we should expect that EPS for many companies could be impacted negatively. An additional headwind for EPS will be higher interest payments. As debt for corporations comes due over the next couple years and they are forced to roll expiring bonds that had interest obligations of 2 to 4% into new bonds at today’s much higher interest rates, interest expense may increase sharply for companies with relatively high debt loads. These are two reasons that I suspect EPS and U.S. stock index levels may not have much room for significant additional price growth in 2023.
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