If you've invested in the stock market over the last couple of years, you may have benefited from an incredible bull run in the S&P 500(SNPINDEX: ^GSPC). The index climbed over 66% from the market bottom in October 2022 through the end of February this year.
But not every stock participated equally in that bull run. If you invested exclusively in large-cap stocks with growth fueled by artificial intelligence spending, you likely outperformed the index. If you invested in anything else, you probably didn't keep up. Just 27% of S&P 500 constituents outperformed the index in 2023, and 28% outperformed in 2024.
That's led to an increasingly concentrated market dominated by just a handful of names. But rising concentration is unsustainable. At some point, the mega-cap stocks that have led the market over the last two-plus years will start lagging as smaller companies pick up the slack. And one market indicator suggests that change could be right around the corner.
Image source: Getty Images.
U.S. money supply growth is accelerating
One factor that's given the biggest companies in the stock market an unfair advantage in recent years has been the tightening money supply. U.S. M2 money supply started declining in 2022, finally reaching a bottom in late 2023.
M2 money supply is a measure of all the cash people have on hand, all the money deposited in checking and savings accounts, and other short-term investments like small-value certificates of deposit (CDs) maturing within a year. The Federal Reserve can influence the money supply through changes in borrowing rates as it works to maintain price stability. A smaller M2 money supply indicates rising interest rates, making it harder to finance loans, and consumers may be less willing to spend.
In January, M2 money supply grew faster than at any point since August of 2022, up 3.86% year over year. The growth has accelerated nearly every month since turning positive 10 months ago. At this point, we've nearly returned to the peak money supply from 2021.
Despite significant economic uncertainty leading to much more caution at the Federal Reserve, investors still expect the Fed to lower borrowing rates further in 2025. As of this writing, futures markets indicate a 79% chance that the Fed makes two to four rate cuts by the end of the year. That should lead to further money supply growth beyond 2025.
How to invest as money supply growth accelerates
While the money supply is tight, mega-cap stocks with tons of cash on their balance sheets stand at a huge advantage. They have the money available to invest in growth and improve their technologies.
The tightening money supply happened to coincide with a major breakthrough in artificial intelligence (AI) in late 2022, which required massive amounts of capital to take advantage of. This enabled the world's largest companies to spend heavily on AI, leaving smaller companies with far less capital.
However, accelerating growth in the money supply is historically correlated with broadening stock performance. As smaller companies have easier and less expensive access to capital, they can invest more in their own growth initiatives. That leads to stronger returns investors typically expect from smaller companies in normal economic environments and more S&P 500 constituents outperforming the overall index.
One of the easiest ways to invest in that trend reversal is to buy an equal-weight index fund like the Invesco S&P 500 Equal Weight ETF. The equal-weight index balances every component of the S&P 500 equally. This means the amount you'll invest in the biggest mega-cap stocks is the same as the smallest members of the index. Each quarter, the index's managers rebalance it, and new constituents are added, while others leave.
The Invesco fund managers do an excellent job of tracking the index and ensuring that the necessary trades to keep the fund balanced don't trigger any capital gains for shareholders. That makes it extremely efficient for long-term buy-and-hold investors.
Other funds for investors to consider include small-cap and mid-cap stocks. These smaller companies have trailed the large-cap index for a long time, predating the Fed's tightening policy over the last few years. However, they now trade at great values relative to the S&P 500. The mid-cap S&P 400 index sports a forward price-to-earnings (P/E) ratio of 15.6, while the small-cap S&P 600 trades for just 15.3 times earnings. That's a bargain compared to the S&P 500's 21.5 multiple or the equal-weight index's 17.1 multiple.
Investors could buy the Vanguard Extended Market ETF(NYSEMKT: VXF), which tracks an index of stocks, including almost every U.S. company outside the S&P 500. Alternatively, a focus on the S&P 600 small-cap index, specifically with the SPDR Portfolio S&P 600 Small Cap ETF(NYSEMKT: SPSM), could perform well as money supply continues to accelerate.
With money supply growth accelerating and valuations favoring smaller companies, all of the above options present great ways to diversify away from the largest companies in the S&P 500.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
