It's Not All Amazon. Small Stocks Are Powering the Market Higher. – Wall Street Journal

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A worker at an Amazon fulfillment center in Italy. Some investors and analysts say it isn’t uncommon for the top companies in the S&P 500, including Amazon, to provide outsize returns.


Photo:

Giulio Napolitano/Bloomberg News

Technology giants get most of the credit for driving this year’s stock-market gains, but the quiet strength of smaller companies is a reason to keep betting on U.S. stocks.

Signs of stock-market breadth are everywhere, investors and analysts say: Smaller-company stocks have climbed more than their larger counterparts this year. When all the companies in the S&P 500 are assigned an equal weighting, the index is still trading near records. And rising stocks have outnumbered decliners this year.

At the same time, strong earnings growth has cooled the lofty valuations that worried investors at the start of 2018.

These factors bode well for the stock market if its high-profile leaders like

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falter, investors say. More than nine years into the bull-market run, many investors are watching for hints of a downturn. Some stumbles over the summer by popular tech stocks, along with recent declines in emerging markets, have stoked fears of a reckoning, but U.S. stocks appear resilient so far.

“Bull markets eventually end, and typically by the time you get to the peak, breadth is gone,” said Bob Doll, senior portfolio manager and chief equity strategist for Nuveen Asset Management. “This is a broad market move. It’s a good thing. It’s healthy.”

Among the quiet winners in the current market are midsize companies. When divided into five groups based on market value, the second and third quintiles of the Russell 1000 index are outperforming the top quintile that houses the biggest stocks, according to data compiled by Strategas Securities LLC. Shares of companies in the second and third quintiles have risen 13% and 12% respectively, this year, beating the 8.7% advance by the largest companies in the index, Strategas data show.

Similarly, although the biggest 10 companies in the S&P 500 at the start of the year have gone on to contribute roughly 45.5% of the broader index’s 2018 total return through Friday’s close, some investors and analysts note that it isn’t uncommon for the top companies in the index to provide outsize returns. In the past decade, the biggest 10 names have contributed an average 30% to the broader index’s annual return, according to Jeff Schulze, investment strategist at ClearBridge Investments. In 2015, they contributed nearly 80%, he said.

“It’s nowhere close to being a potential danger sign for investors to be concerned about a market top,” said Mr. Schulze of the current concentration.

Indeed, even without the 10 biggest contributors—which includes Amazon, up 68%—the S&P 500 would be trading higher. The equal-weighted index, which gives the same weight to both the smallest and largest companies in the index, reached a record in late August—the same day as its more closely followed counterpart.

And the NYSE advance-decline line, a popular indicator of market breadth that measures the net companies rising each day since the start of the year, has climbed, a sign of robust participation in the rally.

One reason for the broad gains: Economic data and earnings growth have been solid across a swath of industries. Another: Many investors, worried about trade disputes, are betting on companies with a greater share of domestic earnings. Those firms are typically smaller than their larger, multinational peers and are receiving more benefits from the corporate tax cut.

The Russell 2000, the benchmark index for smaller-company stocks, has climbed 12% in 2018, eclipsing the 8.7% rise by the S&P 500.

“Everyone’s flocking to the U.S.,” said Kristina Hooper, chief global market strategist for Invesco. “Investors view small- or midcap names with more U.S. exposure as a safe place where they wouldn’t have to deal with the trade war.”

So far, the continuing trade dispute hasn’t taken a big bite out of corporate earnings, a metric many investors say is an important indicator of future stock-market returns. As of Sept. 7, more than 80% of companies in the S&P 500 had reported quarterly earnings that beat estimates, the highest percentage since FactSet began tracking the data roughly 10 years ago. Earnings for companies in the S&P 500 increased 25% in the second quarter, while their smaller-company counterparts in the Russell 2000 posted a 48% jump, FactSet data show.

The strong corporate performance appears set to continue. The estimated earnings-growth rate for the S&P 500 is 20% for the third quarter, while smaller companies are expected to do even better with a 36% increase, according to FactSet. These companies’ earnings are growing at a faster rate than their stock prices, too, quelling valuation concerns. The 12-month price-to-earnings ratio of the Russell 2000 on a forward-looking basis is 22.2 as of Sept. 13, down from 24.2 at the start of the year, while the S&P 500’s ratio is down to 16.8 from 18.1.

This broad earnings growth has also helped push correlations between sectors lower, giving stock pickers a better opportunity to identify winners and losers. Although correlations among technology companies remain elevated, average sector correlations relative to the S&P 500 were 0.6 over the past month through Sept. 11, according to DataTrek research. Between October 2009 and October 2016, the average correlation for U.S. stock sectors was 0.8, DataTrek data show.

A benefit of lower correlations is it protects against large stock-market swings, analysts say. That is helpful to buffet against sector-led selloffs, like early September’s drop in technology stocks. Tech companies in the S&P 500 declined nearly 3% during the first week of the month, while the S&P 500 dropped a more modest 1%.

All 11 sectors of the S&P 500 are expected to report higher earnings in the current quarter, with seven sectors on track for double-digit growth, according to FactSet. And the leaders aren’t technology companies, but energy and financial firms.

“Earnings growth is broad. Lots of companies, lots of industries are participating, and that’s most important,” said Mr. Doll.

Write to Corrie Driebusch at corrie.driebusch@wsj.com