The impact of high interest rates has been overshadowed by the S&P 500

Despite the highest interest rates in decades, why is the performance of the US stock market still outstanding?

The latest market analysis shows that large-cap tech stocks leading the S&P 500 Index, with huge cash reserves, are not significantly affected by interest rate changes. And because the S&P 500 Index is calculated by market capitalization weighting, although small and mid-cap stocks struggling under high interest rates, the overall index is still performing well.

Market-cap weighted S&P 500 Index shields small stocks from suffering

Over the past year, tech giants like NVIDIA, Microsoft, Apple, and Google, known as the "Big Seven Sisters," have led the US stock market amid the AI boom. However, looking back, due to significant differences in interest rate sensitivity between large-cap and small-cap stocks, the performance of the S&P 500 Index as a whole and under equal-weight calculation can be described as "a tale of two cities" - the US stock market has not been unaffected by the Fed's monetary policy, it's just that this impact has been distorted by super-weighted stocks.

As of last Friday, the year-to-date gain of the S&P 500 Index exceeded 10%, while under equal-weight calculation, the gain was less than 5%.

In terms of sensitivity to interest rates, the correlation between the S&P 500 Index and US Treasury yields is much lower than the equal-weight version, which reflects the average performance of the S&P component stocks. Currently, the gap between the two is at its highest level since 1999.

Media analysis points out that if the market is divided into ten equal parts by size, as the company's market value increases, the P/E ratios of each group also show a relatively steady upward trend. The largest tech giants have a forward P/E ratio as high as 21 times, while mid-cap stocks have a forward P/E ratio of 18 times, also higher than historical levels.

The reason is simple, large-cap tech stocks have huge cash reserves and can lock in low-interest debt, and even enjoy high-interest interest income. Small and mid-sized companies lack cash reserves and need to issue bonds, making them more susceptible to high interest rates. So far this year, the small-cap Russell 2000 Index has only risen by 1.6%, far behind the S&P 500 Index.

Investor concerns about "higher and longer" interest rates tend to steer them away from smaller market-cap stocks in the S&P. For example, last Thursday, only 139 component stocks in the S&P 500 Index fell, with most stocks rising, but dragged down by large-cap weighted stocks, the overall market fell by 0.6%.

Once rate cuts begin, small-cap stocks at historically low valuations are expected to catch up

The divergence in performance between large-cap and small-cap stocks is also evident on a broader level. Wall Street News previously mentioned that US April PCE data showed that the month-on-month growth rates of personal income and personal spending in April both declined, and after adjusting for inflation, real personal spending and real disposable personal income in April also decreased by 0.1%, with reduced spending on cars, dining, and entertainment activities by consumersRecent data also shows that real disposable income for American consumers has only seen a slight increase over the past year, with the savings rate dropping to 3.6% , hitting a 16-month low, significantly below the 12-month average of 5.2%.

Similar to the stock market, the most vulnerable parts of the U.S. economy - poorer American households and young people - have already felt the pressure of high interest rates, leading to reduced spending that drags down economic growth. This will further transmit to mainstream retailers, financial companies, and commodity producers. However, unless the U.S. economy falls into a recession, the profitability of tech giants is unlikely to be affected.

Looking at it now, the 50 cheapest stocks in the S&P 500 Index have a median forward P/E ratio of only 15 times, roughly in line with the market's lowest P/E ratio during the post-pandemic downturn, making them very cheap.

Analysts expect that once rate cuts begin, the pressure from high interest rates will ease, and small-cap stocks are expected to catch up quickly with the gains of large-cap stocks