The stock market is approaching a crossroads. U.S. equities hummed along on cruise control for the first four months of 2019, with the S&P 500 rising 17.5% in that time and finishing April at all-time highs. The low volatility and high returns, however, left investors ill prepared for the May whiplash.
The Dow, S&P and Nasdaq all sold off sharply last month, and while stocks have clawed back roughly half of those losses in June, the selloff was a reminder that trade trouble remains a threat to portfolios everywhere.
To be clear, tariffs and trade wars are not the only economic concerns, but they do command enough attention to be a major driver of short-term market movements. If you are invested in equities, you have probably considered how you can shield yourself from trade uncertainties.
Our recommendation: "Think small."
There's a tendency to view the biggest companies with diversified revenue streams as better suited to weather a turbulent stock market. But as trade tensions have escalated in recent months, many megacap stocks with global businesses have actually proved more vulnerable.
The latest round of corporate earnings underscored this trend when companies were sorted by geographic sales exposure. According to data compiled by FactSet Research Systems, companies that generate more than half their sales in the U.S. grew earnings by 6.2% on average compared to a year earlier. For companies that generate more than 50% of sales outside the U.S., their blended earnings declined by 12.8% year-over-year.
In other words, more global exposure has been bad for business.
Trouble beyond trade
Not all of that disparity, of course, is due to tariffs and trade wars. The global economy as a whole has been weaker than the U.S. economy, even before trade policies are factored in. The U.S. dollar has also strengthened roughly 8% in the last 14 months vs. a basket of global currencies, hurting companies who generate more revenue overseas.
Our view is that the environment makes this an appropriate time to consider more exposure to small- and mid-cap U.S. equities. Stocks with smaller market capitalizations tend to have a more domestic focus. That means less impact from existing tariffs and trade uncertainty.
There are other reasons large-cap stocks may offer less shelter from market volatility as we look ahead.
Interest rates have fallen drastically. The 10-year U.S. Treasury yield dropped as low as 2.05% in the first week of June, down from 3.24% only seven months ago. That change has boosted total returns of bonds and higher-yielding securities but if interest rates drift higher from these depressed levels, that will be a headwind for stocks paying large dividends; exactly the kinds of companies investors tend to think of as "defensive."
The news that Congress and the Federal Trade Commission are planning antitrust investigations into some of America's largest technology companies is more motivation to favor smaller-cap companies. Sure, only a handful of stocks are in the cross hairs of politicians' probe into Big Tech. By definition, however, those are the ones with the most influence on major U.S. equity benchmarks.
Each of the five largest weightings in the S&P 500 are Big Tech companies (Microsoft, Apple, Amazon, Alphabet, and Facebook). Together, they represent more than 15% of the index. If your portfolio has a significant amount in large-cap index funds, is that a risk you are comfortable taking?
Small isn't sure thing
Small- and mid-cap stocks, of course, are not immune to market volatility either. Historically, they have exhibited higher highs and lower lows than large-caps. The Russell 2000 lagged its large-cap cousins during the latest selloff, falling 7.9% in May compared to a 6.6% drop for the S&P 500.
It's also important to remember companies can be adversely affected by global trade policies even if they have no direct exposure to international markets. For instance, an American manufacturing company might fabricate and supply internal components to a larger U.S. corporation who sells the final products worldwide. Adverse changes to the larger company's global revenue will trickle down the supply chain with negative consequences.
In other words, some small- and mid-cap stocks won't be as insulated from trade conflicts as others. The companies that provide goods and services primarily to U.S. consumers may well be better positioned.
Ultimately, market capitalization shouldn't be the only tool investors use to evaluate their options, but given the direction tradewinds are blowing, it's not a bad place to start.
Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at ben.marks@marksgroup.com. Brett Angel is a senior wealth adviser at the firm.
