Biggest Performance Difference Ever: NASDAQ and Russell 2000 Divergence

In an unprecedented shift in market dynamics, the tech-heavy NASDAQ Composite and the small-cap Russell 2000 have experienced the largest performance gap on record, a divergence spanning three decades. This disparity is largely influenced by the political landscape and the recent economic trends.

Political Winds Favor Small Businesses

The election of Donald Trump and the potential for a Republican sweep across both the House and Senate have generated optimism for small businesses. Trump’s policies, which include lower taxes and reduced regulations, are perceived as advantageous for smaller companies, traditionally the backbone of the American economy. This political shift has spurred a notable rotation from large-cap tech stocks into small caps.

Earnings Performance: Big Tech vs. Small Caps

Big Tech has delivered impressive earnings results in recent quarters, propelling the NASDAQ to new heights. According to JPMorgan’s strategy team, another “monster quarter” is expected, with estimates projecting a 9.7% growth in S&P 500 earnings for the second quarter—the highest annualized growth since late 2021.

In contrast, the Russell 2000 has faced weak earnings over the past five quarters. Although there are forecasts for improved profits among small caps in the latest cycle, these gains are unlikely to sustain the recent rally in small-cap stocks. The substantial earnings gap underscores the performance disparity between the NASDAQ and the Russell 2000.

Market Liquidity and Economic Indicators

With liquidity on the rise and robust earnings from large-cap tech stocks, the markets could see continued upward momentum following a brief pause. Both the NASDAQ Composite and the S&P 500 benefit from their heavy weighting in tech giants. However, upcoming economic indicators, such as Friday’s Personal Consumption Expenditures (PCE) and next week’s jobs report and Federal Reserve testimony, will be critical in determining market direction. These reports will provide key insights into inflation, economic health, and future guidance.

Shift in Market Trends

The recent market selloff, driven in part by a rotation into small caps, was anticipated due to the overbought conditions in tech-heavy averages. The attempted assassination, which dramatically increased the likelihood of a Republican-controlled Congress and Presidency, marked the beginning of this shift. Historically, smaller companies thrive under Republican leadership, which often prioritizes business-friendly policies.

Additionally, the ongoing trends in Quantitative Easing (QE) continue to fuel inflation. The utility of AI and the high probability of a Republican victory in the upcoming election year further support the current market dynamics.

Federal Reserve and Global Liquidity

With lower inflation and rising unemployment, the Federal Reserve is expected to cut rates, as indicated by the CME FedWatch, which anticipates three rate cuts by the end of the year. This trend suggests that global liquidity, which has slowed in 2024, will likely rise later this year. Central banks may need to increase liquidity to address economic challenges, reinforcing the trend of growing market liquidity.

In summary, the record-breaking performance gap between the NASDAQ Composite and the Russell 2000 reflects a complex interplay of political developments, earnings disparities, and market liquidity. As the markets navigate these dynamics, the ongoing influence of big tech and the potential for a Republican-led government will be pivotal in shaping future trends.

Adding Exposure to Small Caps in My eToro Portfolio

Given the current market dynamics and the potential for political shifts favouring small businesses, I have decided to add Small Caps to my eToro portfolio.

Despite the recent underperformance of small caps relative to large-cap tech stocks, the political environment and economic indicators suggest a favourable outlook for the Russell 2000.

The rotation into small caps, driven by expectations of lower taxes and reduced regulations under a possible Republican-controlled government, presents a good investment opportunity.

This strategic adjustment aims to leverage the anticipated benefits for small businesses and align with the broader market conditions favouring smaller companies in the near future.

By incorporating small caps into my portfolio, I seek to enhance potential returns and balance the concentration of tech-heavy investments, ensuring a more diversified and resilient investment strategy amidst evolving market conditions.