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Financial Buzzword of the Year: “Bifurcation”

Third Quarter 2024

“A rich man is nothing but a poor man with money.” – W.C. Fields, Actor

As 2024 has progressed, we have repeatedly heard the word “bifurcated” in financial news, economic research reports, and company earnings calls.

            Bifurcated: (def) divided into two branches or parts

This word is being used in reference to a number of different trends we are witnessing in both consumer financial health and equity markets in general:

  • Consumers: High-income earners and low-income earners began to show a sharper divide in both consumer confidence and debt delinquency rates over the past year.
  • Equity Markets: Large capitalization (“cap”) stocks (specifically mega cap stocks) have continued to significantly outperform their small cap peers.

Consumer Bifurcation

While there is always a divide between how high-income and low-income earning families perceive the economic environment and adjust their spending and saving, this rift seems to have widened in the past year or two.

The rate of credit card delinquencies that had been rising for the last year has begun to slow, a good sign overall for consumer financial health. However, this masks the fact that high-income earners have been paying their cards down, while low-income earners have been falling further behind.

Per a credit score company CEO in May:

“That lower income consumer is increasingly falling behind on their credit balances and that’s really where we’re seeing the localization of the increased delinquencies.”

This fact may weigh heavily on how low-income earners perceive their economic prospects. Consumer sentiment, a leading indicator of consumer confidence and of the economic outlook over the next six months, increased for both income levels over the past two years. However, the increase was far greater for high-income households, as inflation has taken far more of a bite out of the wallets of low-income consumers.

Market Bifurcation

Over long periods, small-cap stocks have generally kept up with large-caps and even substantially outperformed them at times. This may be primarily because small caps include industry “disruptors” with new technology and higher growth potential. Large caps, while typically the leaders in their industries with stable and reliable growth, often fall prey to these smaller, more flexible and focused businesses. While large caps are sometimes given near monopolistic power due to their size and position, nearly every industry succumbs to these cycles over time.

Recently, however, large cap companies in several sectors have used their size, technology, and power to pull away from smaller competitors and continue to use their scale to take a larger market share or dominate brand new industries. For example:

  • In the technology sector, giants such as Microsoft, Alphabet, and Amazon are dominating the cloud computing space and squeezing out competitors with their size and scale. Along with Meta, these companies are also at the forefront of the new AI industry, and are acquiring smaller competitors in the space to try to ensure they remain in the lead.
  • These major players in AI require the most efficient microchips to maintain their lead and continue to grow—a fact that has driven one leader in the field to a new plateau in its dominance. NVIDIA’s semiconductor architecture is so well designed for AI applications and the large cap tech giants’ pockets so deep, that in June of 2024 NVIDIA briefly became the largest company in the world based on market capitalization.
  • JP Morgan Chase, the nation’s largest bank, attracted billions in customer deposits from those fleeing the regional banking crisis in early 2023. Due to the bank’s size, regulators restrict JP Morgan from significant acquisitions during normal periods. However, due to an emergency exemption and their strong financial position, JP Morgan won the bidding to acquire First Republic Bank, a troubled regional bank, at what may prove to be a discount to its intrinsic value.

Small cap companies also tend to be burdened by more debt as a percent of their balance sheet than their larger peers. Therefore, as interest rates rose in 2022, the impact disproportionally affected small caps. On the flip side, many large cap companies, specifically mega cap technology companies, are sitting on billions in net cash, and benefiting from a higher interest rate environment as they are able to earn a sizeable return on these reserves.

The bifurcation trend is also evident in stock prices. Since 2018, large caps have significantly outperformed small caps, despite the surprising fact that small caps have actually grown their earnings at a faster rate during this period. The key difference lies in investor expectations. Large companies are anticipated to deliver higher future revenue and earnings growth, justifying a much higher valuation (price-to-earnings multiple) compared to their smaller counterparts. As clear evidence, consider that the S&P 500 Index currently sits at a P/E of near 26x, while the S&P Small Cap 600 Index has a P/E of only 16x.

Bifurcated For How Long?

Mean reversion, the idea that “bifurcated” data points will eventually move back toward their historical average, suggests that the current gap between large-cap vs. small-cap stocks may eventually close. However, mean reversion may not apply the same way to economic perceptions or prospects with regards to lower income households, which are primarily dependent on employment opportunities, wage growth, interest rates and inflation. At Mitchell Sinkler & Starr, we strive to remain cognizant of how this might affect our clients and their various investment goals and objectives.

– Mitchell Sinkler & Starr’s Portfolio Managers

 

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