Stock markets in 2023 are not quite what they seem.
At first glance, the pessimists are taking a beating. Investors and influential analysts had entered the year expecting 2022′s aggressive series of interest rate rises to bite. The consensus was for an economic recession to hit the US, dragging stocks down.
That has not happened, despite a series of regional bank failures in the spring that compounded the impact of rising rates. The American economy is still growing and the S&P 500 index, which measures the performance of US blue-chip stocks and sets the tone for investors around the world, has climbed more than 14 per cent this year. With two weeks still to go, this is already one of the best half-years for the index in two decades.
But this is a rally standing on top of some very slender stilts. Strip out just a tiny clutch of companies, all tech heavy-hitters, and the index is going nowhere.
“Typically with things like this, when only a small number of stocks are doing well, you get overvaluation and speculative behaviour — everyone pumps money into these stocks, and we have another tech bubble like we did in the late 90s and early 2000s,” says Remi Olu-Pitan, multi-asset portfolio manager at Schroders. “You can argue that maybe we’re sowing the seeds of that.”
Top heaviness, particularly in US markets, is not new. “The big tech stocks in the S&P now are the same situation as oil companies were in the past, or the Nifty 50 in the 1960s,” says Frédéric Leroux, head of the cross-asset team at Carmignac in Paris — a nod to the craze that swept shares in a small number of fast-growing companies such as IBM, Kodak and Xerox higher before a heavy decline set in. “It’s a problem, but it’s a recurring problem.”
But by many measures, it has now reached striking extremes, masking a humdrum performance from the vast majority of stocks and complicating investment decisions both for those who pick stocks and those who prefer to track indices. Some warn it is unsustainable or a sign of treacherous market conditions ahead.
The performance of the S&P 500 index is now the most concentrated it has been since the 1970s. Seven of the biggest constituents — Apple, Microsoft, Google owner Alphabet, Amazon, Nvidia, Tesla and Meta — have ripped higher, gaining between 40 per cent and 180 per cent this year. The remaining 493 companies are, in aggregate, flat.
Big tech companies dominate the index to an unprecedented degree. Just five of those seven stocks represent nearly a quarter of the market capitalisation of the entire index. At US$2.9 trillion (NZ$4.6t), Apple alone is worth more than the UK’s top 100 listed companies put together.
The chipmaker Nvidia, riding the wave of investor enthusiasm over artificial intelligence and ripping up its own revenue guidance for the coming quarters in favour of more bullish predictions, has gained US$640 billion in market capitalisation just this year. That is almost as much as the combined market worth of JPMorgan and Bank of America, the two biggest banks in the US.
Ed Cole, managing director in discretionary investments at Man GLG, says the soaraway performance of a sliver of stocks has stirred a renewed so-called fear of missing out, or Fomo, among some investors.
“The danger is if you have gone all-in,” he says. “For people caught up in Fomo who have gone all-in on this very narrow theme, if you discover there are competitors that can enter the marketplace, it does not take very much for your position to reverse quite meaningfully.”
Index tracking and ESG
The AI explosion has been a big short-term driver of this concentration, but the clustering has deeper roots. Some of it simply reflects the US’s global leadership in consumer-facing technology, which over decades has created a series of highly profitable and highly durable companies of the sort that investors love. Even Warren Buffett, the consummate value investor, has bought shares in Apple and some other tech stocks.
As their market capitalisations grew, they constituted an ever-larger proportion of the S&P 500, which like most stock indices weights its constituents according to their market value. Two wider market trends compounded this. One was an accelerating wave of so-called passive investment, where funds simply seek to replicate the performance of an index by mirroring its composition. This meant that as these stocks went up, so too did their index weights, forcing funds to buy more of them.
The other was so-called ESG investment, a style that focuses on environmental, social and governance as well as financial factors. Growing interest in ESG has pushed investment dollars into tech at the expense of carbon-heavy sectors such as oil and gas. Active investors, passive investors, momentum chasers and ESG funds are often all chasing the same targets.
The thorny question is whether this is a problem.
It certainly gives an odd impression of market health. Michael Wilson, chief US equity strategist at Morgan Stanley and one of the most prominent Wall Street analysts warning of a pullback in stocks, says the winning streak by a “handful of mega-caps” is obscuring broader pain in the market.
“A major repricing has occurred... led by lower quality, cyclical, and small-cap stocks,” he said this month, reiterating that he expects the index to wrap up the year at 3900, which would represent an 11 per cent drop from current levels.
The OECD is watching with interest, saying in recent research that the vast scale of a few companies, combined with the widespread use of investable indices in passive investment products, has increased the tendency for stocks to move together — a phenomenon that can amplify both positive and negative shocks.
It could also help to crimp small companies’ growth, the Paris-based international body warned. “OECD research primarily points to possible effects on smaller companies’ ability to access financing from public markets,” it said. “This can possibly limit the available financing available for smaller, innovative companies and new business models.”
Almost instinctively, this intensifying phenomenon is unnerving analysts and investors alike.
French asset manager Tobam has also long warned its clients that this concentration in tech stocks complicates the investment process for everyone from individual investors to big pension funds. It makes it impossible to diversify risks by tracking a broad index such as the S&P, but also tricky to be a stockpicker when only a small clique of stocks is performing well.
“It does not make sense,” says Alex Cabrol, a managing director at the Paris-based firm. The unravelling of the phenomenon is “not a question of ‘if’, it’s a question of ‘when’ ”, he adds, pointing out that previous similar episodes, most notably in the dotcom bubble of 2000, were followed by ugly declines.
Mutual funds are also stumbling over this dynamic. Analysis from Goldman Sachs last month, looking at more than 500 such funds with a combined US$2.6t in assets, found that the “extreme concentration” in the Russell 1000 growth index was clashing with rules that required funds to maintain diversified portfolios or limit exposure to individual companies.
These rules mean the average large-cap US mutual fund holds smaller positions in seven stocks, including Apple, Microsoft and Nvidia, than their index positions would warrant. Fund performance, relative to the index, is suffering as a result. “The outperformance of mega-cap tech has been a significant headwind to core and growth mutual funds,” the bank said.
Catch up, or fall down
One of the trickiest elements for fund managers is that the concentration can resolve in one of two ways: either the rest of the market catches up with the leaders, or the high-fliers fall back down to earth.
This is fast becoming one of the fiercest debates in finance. At heart it is a question about whether the US economy is heading towards a recession that drags down corporate earnings or towards a soft, even barely perceptible economic landing in which the Federal Reserve somehow nurses inflation lower without harming the economy along the way — the so-called “immaculate disinflation”.
Cole, of Man GLG, says a durable catch-up would rely on “fantastic” earnings from the rest of the companies in the index — an unlikely outcome given his long-held expectation for an economic slowdown. A short-term pick-up is, however, “plausible”, he says. “Would I put capital to work on it? No. But it’s plausible.”
Goldman Sachs is more upbeat. This month, it lifted its target for the S&P 500 for the end of this year, forecasting that it would reach 4500 — a 12.5 per cent increase from its previous forecast and about 3 per cent above where it was on Wednesday afternoon. If the bank is right, this will be one of the strongest years for the index of the past two decades.
Part of its reasoning is that, looking at previous episodes of intense concentration since 1980, broad market performance has been tricky, with stocks often trading sideways for long periods or suffering unusually large declines. “Eventually, however, a ‘catch-up’ has been the most common [outcome],” it said.
The bank’s above-consensus view on the US economy — it assigns a 25 per cent probability to a recession over the next 12 months, against a 65 per cent estimate by the median forecaster — also means it thinks a catch-up is more likely than a catch-down.
In the same vein, Max Kettner, chief multi-asset strategist at HSBC, said the narrowness of the market had become an “obsession of bearish commentators and investors”.
“[US equity market] breadth is as bad as it’s ever been in history,” he wrote in a note to clients. But, he added, this in itself did not throw off strong, reliable trading signals. On the margins, it may even be positive. “If anything, the immediate performance following weak market breadth is better compared to when equity market breadth is strong,” the note concluded.
Analysts at Barclays said they had spotted tentative signs that investors were starting to give up on the gloom. “Following nearly three months of wait-and-see mode, cautious but also cash-rich investors appear to have finally thrown in the towel and started chasing the rally,” the bank said.
The buying was spreading beyond just those tech names, it said, which “could in fact be a prelude to a sustained breakout from the recent trading range”.
For now, market bulls and bears alike are using this narrow markets phenomenon to further their case. But the broader global financial ecosystem may be weaker and less varied for it.
“Capital markets have become a champions league,” says Carmine Di Noia, director for financial and enterprise affairs at the OECD, referring to the elite European football championship. “They are not only dominated by large issuers but also by large asset managers, asset owners, index providers and audit firms. There is concentration in all parts of the market.”
Written by: Katie Martin and Nicholas Megaw
© Financial Times