In the past six months there has appeared to be a disconnect between the strength of stocks in the S&P 500 and all other companies, both public and private. Indeed, earnings growth has been much more impressive among large companies than small companies, which is a fairly rare event.
For insight on why this might be occurring, let’s turn to an analysis by a different team at Goldman Sachs, whose research I respect. Here is their view as to why earnings growth is so much faster in the S&P 500 than the rest of businesses:
More foreign exposure. The average S&P 500 company gets about 30% of its revenues from abroad. Foreign growth has outpaced the U.S. so far in this recovery: We estimate that U.S. trading partners grew at more than a 5% rate (year-over-year) in the first half of 2010, nearly double the rate of U.S. growth. To boot, the value of the dollar fell versus these trading partners on average, making foreign earnings even more valuable in U.S. dollar terms.
A more cyclical sector mix. The S&P 500 tends to contain larger firms in industries such as manufacturing where scale is important. Sectors with lots of small and/or private companies, like construction and professional services, are underrepresented. This is important because on average the S&P companies are concentrated in sectors of the economy that tend to show greater cyclical fluctuations, which means their share of corporate profits rises in expansions and falls around recessions. This explains in part why they have grown faster than others over the past year of recovery.
Easier access to credit. The credit crunch of 2008 and its aftermath has been particularly damaging for small companies, who generally rely on relationships with one or two regional banks. Large firms such as those in the S&P 500 index typically have more financing options, and thanks to a fairly swift recovery in the capital markets, can often fund themselves directly in the market at attractive rates. The result has been consolidation in harder-hit sectors such as home building that have traditionally featured a plethora of smaller private firms.
Selection bias. Last but not least, the S&P 500 companies have been chosen for the index in part because of their past (and recent) growth and success. This is an important reason why historical data show these companies growing faster than the overall economy. If performance shows at least some positive correlation from one period to the next, and index managers continue to exhibit a bias for better-performing companies, companies in major stock indexes should continue to outperform the corporate sector as a whole.
I would also add that larger companies tend to pay larger and more consistent dividends, which is another major factor driving stock prices this year. For these reasons, I recommend sticking primarily to the large-cap stocks over the rest of the year.
For more ideas like this, please check out Jon Markman’s daily trading advisory service Trader’s Advantage, or my long-term investment letter, Strategic Advantage.
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