A major disconnect is happening in the US stock market
In 1980, the total value of small businesses in the private sector stood at approximately $2 trillion.Past performance isn’t a reliable indicator of future results
If we fast forward to the present day, we see something incredible. The size of the small business market cap has grown to become about $15 trillion. Meanwhile, the S&P 500 index now stands at a massive $54 trillion in market cap.
We've seen the largest 500 companies completely engulf the rest of the economy over the past 45 years
Amazon has been competing with local retailers with 90% of them stating that Amazon has negatively impacted their revenue. The largest five banks in the United States, including JP Morgan, have grown their market share by a factor of four since 1990 through acquisitions, branch expansions, and more significant resources. 9.8% in 1990, 43% in July 2025. And we've had the same theme with big pharma, such as Johnson and Johnson are buying up small biotech firms before they even have a chance to generate meaningful revenue. Costco and Walmart dominate with their scale, offering prices smaller stores simply can't compete with. The list can go on. Scale, capital, and technology have given large caps companies a huge advantage.
This isn't just a long-term theme. It's being reflected in the earnings of companies in the present day. This is what the earnings of large cap companies looks like from May of 2022 till May 2025. And this is what small cap earnings have been doing over the same time period. So we've seen this trend happen in real time at an accelerated pace in recent years.
This is a challenging environment for the economy. Small businesses are said to be the backbone of the economy. They represent 99% of all businesses in the United States and are responsible for roughly 50% of the employment market. The economy cannot run on just a handful of large corporations, which suggests that small businesses continue to play an important role.
So the big question now is what's next?
This is actually not the first time we've seen this. This chart shows the overall waiting of top 10% largest US stocks going back to the 1930s. Today, they make up about 75% of the entire index, one of the highest levels ever. This is a great historical representation of the underlying theme we talked about earlier of a handful of corporations eating up a larger and larger portion of the economy.
And we've seen similar moments before. In the 1920s, it was the big industrials and utilities. In the 1960s, it was a group of 50 large cap stocks called the Nifty50. In the 1990s, it was dotcom companies. Each of these peaks marked moments where a handful of companies were dominating the economy. All of them were reversed.
Since 1990, we've been in a structural uptrend with market concentration steadily increasing. And more recently, this has steepened and reached the highest level since the Great Depression. Some speculate that AI will push the large companies towards even more domination in the coming years, but others suggest we could see at least a temporary reversal here.
This chart shows the valuations of large cap companies and small cap ones. There's a historical gap between the two. The S&P 500 trades at 22.2 times earnings, while the small cap S&P 600 sits at just 15 times. This is typically the first criteria that we tend to see when concentration is reversed. Some analysts note that large caps may have less room to expand, while small caps appear comparatively lower in valuation, but textbooks always say valuation aren't a timing tool. The gap has been like this since 2020.
What if it just continues like this?
And you would absolutely be correct in pointing that out. This valuation gap we're seeing now could just stay wide for long periods in the future. There needs to be some kind of a catalyst to drive valuations up or down. There needs to be some kind of a shift in the underlying fundamental story that changes how investors think about how attractive the smaller companies are relative to the larger ones.
And some analysts have pointed to a few such factors. First of all, after 3 years of stagnation, small cap profit margins are finally ticking higher. Since 2024, margins in the S&P 600 have climbed from around 6% to nearly 7%, a 15% improvement. Profit margins are one of the clearest leading indicators of future growth. When they rise, it means companies are regaining pricing power, cutting costs, and freeing up more capital to reinvest back into their business. These kinds of improvements are often seen as strengthening fundamentals.
Still, margin gains can prove temporary. Small caps are more exposed to swings in input costs in labor markets, meaning these improvements may not hold if conditions change. But it is not the only catalyst we have seen right now. Back in 2022 through 2023, small cap's profit margins were squeezed because of the high levels of inflation that was hovering above 4% and high interest rates that were also stuck at high levels. For small businesses, that combination was devastating. Rising inflation meant higher costs for labor, energy, and raw materials. At the same time, higher interest rates translated directly into more expensive borrowing. Small cap companies already carry more debt relative to large caps and start off with thinner margins. So, the pressure hits them much harder.
Today, however, the inflation shock has mostly cooled
The inflation rate is now at 2.9% and that has finally given the Fed room to cut rates. Since late 2024, the Fed has already cut rates three times and is expected to ease even further this year. This removes the tough monetary policy conditions that made small businesses particularly vulnerable between 2022 and 2024. Some analysts believe it could create a more favorable environment for them.
On the other hand, rate cuts sometimes happen because the economy itself is weakening. And in those environments, smaller companies have historically been more vulnerable than large cash rich firms. So, let's take a look at the previous instances when the Fed started easing after a monetary tightening cycle. Here, we overlay the Fed funds rate with the small cap index's performance relative to the S&P 500. When the Fed shifts from tightening to easing, like in 2008, 2001, and 1990, small caps tend to outperform the broader market.
However, today, as we can see, despite these changes in the macro environment, small caps have continued to underperform against the S&P 500. But some analysts suggest we may be starting to see some shifts happening underneath the surface. This chart shows something called the NFIB Small Business Survey. It tracks how owners see their business outlook over the next six months and has turned sharply higher since the Fed began easing in September 2024. Today, there are 36% more businesses expecting conditions to improve than those expecting things to get worse. That's one of the strongest readings we've seen in years. Sentiment has quickly changed from pessimism to optimism.
We can also tell this by looking at the number of new business applications in the US. As we can see, it's rising again for the first time in decades. Right now, we're seeing around 75,000 applications being filed. A clear sign that entrepreneurs are confident enough to start new ventures and have a healthier outlook for the economy ahead.
So, looking at all of these catalysts, some analysts argue that we may be at a turning point. Small caps have gone practically nowhere since 2021, while the NASDAQ and S&P 500 have surged 50% and 70%. Now, with valuations sitting at a deep discount, macro conditions finally shifting in their favor, and business optimism turning higher, analysts are watching closely for whether this could lead to a rotation in capital flows. Still, small caps remain more volatile than their large cap peers. Even with supportive conditions, outcomes could range from a recovery in relative performance to continued underperformance if economic or financial pressures reemerge.
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