The stock markets of 2023 will not be as they appear.
Pessimists seem to be suffering at first glance. Investors and analysts expected the aggressive rise in interest rates that will occur by 2022 to be a reality. It was widely believed that the US would experience an economic downturn, which would drag stocks down.
This has not occurred, despite the fact that a number of regional bank failures during the spring compounded the effect of rising interest rates. The American economy continues to grow and the S&P 500 Index, which measures performance of US blue chip stocks and sets the trend for investors worldwide, has risen more than 14% this year. This is one of the best halves-years in the index’s history, and there are still two weeks left.
This is a rally on stilts. If you remove a small group of tech giants, the index will not move.
“When only a few stocks do well, it usually leads to overvaluation and speculation. Everyone pumps money into the stocks and we get another tech bubble, like we had in the early 2000s,” explains Remi Olu Pitan, Schroders’ multi-assets portfolio manager. You can argue that we are sowing the seeds for that.
It is nothing new to see top-heavy markets, especially in the US. “The big tech shares in the S&P are in a similar situation to oil companies in the past or the Nifty fifty in the 1960s,” Frederic Leroux says, head of Carmignac’s cross-assets team in Paris. He is referring to the craze which swept up shares of a few fast-growing companies like IBM, Kodak, and Xerox before a steep decline. It’s not a new problem.
It has reached extremes by some measures. This masks a lackluster performance of the vast majority stocks, and complicates investment decisions for both those who choose stocks, and those who track indices. Some say it’s unsustainable, or that it could be a sign for treacherous conditions in the future.
S&P 500 performance is the most concentrated since the 1970s. Apple, Microsoft and Google’s Alphabet (which owns Alphabet), Amazon, Nvidia and Tesla, as well as Meta, are the seven largest constituents. They have all soared this year, with gains ranging from 40 to 180 percent. In aggregate, the remaining 493 companies have remained flat.
The index is dominated by big tech companies to an unprecedented extent. Five of these seven stocks account for nearly a quarter the total market capitalisation. Apple is alone worth $2.9tn more than all 100 UK listed companies combined.
Nvidia has seen its market capitalisation increase by $640bn this year, thanks to the investor enthusiasm for artificial intelligence. The chipmaker has also rewritten its revenue forecasts in favor of more optimistic predictions. This is nearly as much as JPMorgan’s and Bank of America’s combined market value, two of the biggest US banks.
Ed Cole, Man GLG’s managing director for discretionary investments, said that the performance of just a few stocks had rekindled the fear of missing out (Fomo) among investors.
He says that the danger comes when you go all-in. “For those caught up in Fomo, who have gone all-in, if there are competitors entering the market, your position can change quite significantly.”
This concentration has more than just a short-term impact. It has deeper roots. It’s partly due to the US’s dominance in consumer technology. This has led to a number of companies that are highly profitable and durable, the kind of businesses that attract investors. Even Warren Buffett the consummate value-investor has purchased shares in Apple, as well as some other tech stocks.
The S&P 500 index, like many other stock indices, weights its constituents by their market value. This was compounded by two wider market trends. The first was the accelerating trend of passive investments, in which funds seek to mimic an index’s performance by simply mirroring its composition. As these stocks rose, their index weights also increased, forcing funds into buying more.
ESG investing is a style of investment that emphasizes environmental, social, and governance factors as well as financial ones. The growing interest in ESG is driving investment dollars to tech, at the expense carbon-intensive sectors like oil and gas. Investors, whether they are active, passive, or ESG funds, all chase the same target.
The question that is most difficult to answer is whether or not this is a serious problem.
It gives a strange impression of the market’s health. Michael Wilson, Morgan Stanley’s chief US equity analyst and one of Wall Street’s most prominent analysts who has warned of a market pullback, said that the winning streak of “a handful of mega-caps”, is masking the broader pain of the market.
“A major repricing occurred. . . He said that the index will finish the year at 3,900. This would be an 11 percent drop from the current levels.
The OECD has been watching closely, stating in a recent study that the large scale of a handful of companies combined with the widespread usage of investable indices for passive investment products have increased the tendency of stocks to move in tandem — a phenomena that can amplify positive and negative shocks.
The Paris-based international organization warned that it could also crimp the growth of small businesses. The OECD’s research focuses on the possible impact of smaller companies being able to access public markets for financing, it says. This could limit the financing options for innovative, smaller companies.
This intensifying trend is unnerving to both analysts and investors.
Tobam, a French asset manager, has warned clients for years that the concentration of tech stocks can complicate investment decisions. This is true for both individual investors and pension funds. This makes it difficult to diversify risk by tracking an index like the S&P. It is also hard to pick stocks when a small group of stocks are performing well.
Alex Cabrol is the managing director of a Paris-based company. “It doesn’t make sense”, he says. He adds that the unraveling of the phenomenon “is not a matter of ‘if,’ but a matter of ‘when,'” pointing out previous similar episodes such as the dotcom boom of 2000 were followed by ugly falls.
Mutual funds also stumble over this dynamic. Goldman Sachs’ analysis of more than 500 funds, with $2.6tn worth of assets, revealed that “extreme concentration” within the Russell 1000 Growth Index was in conflict with the rules requiring funds to have diversified portfolios and limit their exposure to specific companies.
The average US large-cap mutual fund, which includes Apple, Microsoft, and Nvidia in its portfolio, holds smaller positions than the index would suggest. As a result, fund performance relative to the index is suffering. The bank stated that “the outperformance of megacap tech has been an important headwind for core and growth mutual fund.”
Fund managers face a tricky situation when it comes to concentration. It can either resolve itself in two ways: the rest of market catches up or the high-fliers come back down to Earth.
It is becoming a heated debate in finance. It is about whether or not the US economy will be heading into a recession which will drag down corporate earnings, or towards a soft and barely perceptible economic landfall in which the Federal Reserve manages to keep inflation low without damaging the economy — the “immaculate deflation”.
Cole, from Man GLG, believes that a catch-up is unlikely, given the fact that he has long predicted a slowdown in the economy. He says a short-term recovery is “possible”. “Would i put capital to it? No. “But it’s plausible.”
Goldman Sachs has a more positive outlook. It raised its target for S&P 500 at the end of the year. The bank forecasted that it would hit 4,500, a 12.5% increase over its previous forecast, and about 3% above where it stood on Wednesday afternoon. If the bank is correct, this year will be the best for the S&P 500 index in the last two decades.
Its reasoning includes the fact that, when comparing previous episodes of intense market concentration, since 1980, stock prices have often traded sideways or experienced unusually large drops. It said that “catch-up” was the most common outcome.
It also believes that a catch up is more likely than an economic catch-down, due to its above-consensus outlook on the US economy. The median forecaster estimates a 65 percent probability of a recession in the next twelve months.
Max Kettner is the chief multi-assets strategist at HSBC. He said that the narrowness of market has become “an obsession of bearish commentators, and investors”.
In a letter to clients, he said that the “breadth of [the US equity market] is as bad as ever.” He added that this alone did not produce strong and reliable trading signals. On the margins it could even be positive. The note concluded that “if anything, the immediate results following weak equity market breadth are better than when equity market spread is strong.”
Barclays analysts said that they’d seen some tentative signs of investors giving up on the doom. After nearly three months in wait-and see mode, cautious and cash-rich investors have now started to chase the rally.
It said that the buying had spread beyond those tech names and “could be in fact a prelude for a sustained break from the recent trading range”.
Market bulls and market bears are both using the narrow markets phenomenon for now to advance their respective positions. The global financial system may suffer as a result.
Carmine Di Noia is the director of financial and enterprise affairs for the OECD. He refers to the European elite football championship. They are not only dominated but also by asset managers, asset owner, index providers, and audit firms. All parts of the market are consolidated.