Market Dynamics Are Different Today
The S&P 500 has been on one of those historic runs as it comes off its fifth consecutive weekly gain and up 14 of the past 15 weeks. Since the late-October lows the S&P 500 is up more than 20% and up more than 5% in the opening six weeks of this year. However, I’m seeing signs in metrics I follow that equities are getting stretched here. Not the entire equity market mind you, as we did see some constructive broadening in breadth metrics to close out last week with advancers outnumbering decliners by a 2-to-1 margin on both the NYSE and the Nasdaq exchange. While market concentration is getting extreme, we are seeing pockets of strength in the equity market beyond just A.I. and tech – namely healthcare, construction and industrial stocks, transports, and the left for dead Chinese equity market which is giving a lift to Emerging Markets as a whole.
The move up in bond yields so far this year on the back of resetting rate cut expectations for further into the calendar looks to have run its course. The swaps curve is now pricing in cumulative interest rate cuts of roughly 110 basis points by the Fed’s December meeting. Coming into the year these expectations were up at 160 basis points of cuts and odds for March being the start of the cutting cycle have melted down to 15% and just over coin flip odds that we get a cut at the May 1st Fed meeting. Tuesday’s CPI inflation data will be the next big data point for investors and policy officials to fold into their outlook on the future path of interest rates. Expectations are for the year-over-year headline figure to slip below 3% and the core metric to slide but remain in the high-3’s. Recall what Powell went out of his way to say in his last press conference and again on 60 minutes about incoming data, “doesn’t need to be better than what we’ve seen, or even as good. It just needs to be good.”
Let me pick this missive back up where I started and that is with some thoughts on the exuberance getting priced into some areas of the market. The Nasdaq is now 7% above its 50-day moving average, almost 13% above its 100-dma, and 17% above its 200-dma and as a result has become completely overextended. What we are witnessing in real-time is how momentum, speculation, and sentiment can be powerful drivers of stock market price action. Over the past decade-and-a-half we have transitioned to an environment where price and momentum have become the dominant variables in investors’ decision-making process. This isn’t to say there aren’t mindful investors out there making investment decisions on the basis of balance sheet quality, free cash flow growth, valuations, and management quality, but those adhering to such rigor have been relegated to underperforming. In all sincerity I am starting to think that such work has become a handicap for investors.
I know, I know, that’s blasphemy coming from you Corey. Afterall, you’re charged with being the stewards of other people’s money, but yet you’re admitting the increasing likelihood of being unable to compete with a plain vanilla index fund like the S&P 500. Yes, yes I am. Work with me here, as I don’t want the takeaway from this message to be interpreted as a complaint or “that’s not fair” (a tried and true one from my daughter Alexandra), but rather providing context for the structural changes underway in the functioning equity markets. David Einhorn of Greenlight Capital was interviewed last week on the “Masters In Business” podcast by Barry Ritholtz where David makes the proclamation that ‘market structures are broken and that value investing is dead”. I encourage you to listen for yourself as David is one of the most thoughtful and rigorous investors of this generation. He doesn’t make statements like that without evidence to back it up and his articulation of his view is best heard first-hand.
But the basic principle underlining this claim is the mass adoption and unrelenting usage of passive indexes by investors to gain exposure to equities. As I’ve said before and I’ll repeat again, indices via etf’s or mutual funds were created as a low-cost broad-based way for investors to get exposure to markets and it was a revolutionary financial innovation. However, with passive investing now pushing above 50% of investors equity market exposure and continuing to grow, it risks becoming a destructive force rather than the constructive force it set out as.
Consider the market concentration we are seeing develop right in front of us. The top 10 stocks in the S&P 500 (Microsoft, Apple, Nvidia, Meta, Alphabet, Amazon, Berkshire Hathaway, Eli Lilly, Broadcom and Tesla) now constitute the largest collective weighting in the S&P 500 in the last three decades.
In 2010, the top 10 stocks constituted 19% of the S&P 500's market cap and were responsible for around 19-20% of the index's earnings. By the end of January 2024, the top 10 stocks represented 32.5% of the index's market cap and still 20% of earnings. The most prominent companies have grown in market value more than their earnings growth, leading to increased valuation multiples despite rising interest rates.
The debate is whether this is an expected function of high-quality companies gaining market share with the potential for huge forward growth or whether this is a byproduct of the outsized effects of passive index investing, where money automatically flows into these stocks regardless of their earnings performance and largely beyond the market's capacity to absorb the flows. Regardless of your conclusion, this concentration raises questions about market structure and stability, as a significant portion of the index's performance and investor returns are tied to the fortunes of a small number of firms.
At the moment, Microsoft wears the crown of having the largest market capitalization at $3.125 trillion and this is an American record for the most valuable public company ever (topping the mark set by Apple last summer). This likely comes as little surprise to most investors, but did you know that this is nearly twice the size of the entire S&P 500 energy sector, at $1.6 trillion. Over the past year the total free cash flow generated by Microsoft was a whopping $67 billion, but this is less than half the $135 billion generated by the S&P 500 energy sector.
Let’s do a similar comparison with Nvidia, everyone’s A.I. darling. With Nvidia’s stratospheric rise over the past twelve months its market cap is just shy of $1.8 trillion or $200 billion higher than the company’s making up the S&P 500 energy sector. Charlie Bilello put out the following table on X (see below) illustrating the disparity in total net income over the past twelve months of the energy sector ($147 billion) and Nvidia ($19 billion).
The point I’m trying to make with these comparisons isn’t about the investment merits of Microsoft and Nvidia versus the energy sector, but rather to point out an obvious change in what equity markets are pricing. Common sense tells you that technology needs energy to function, so you can’t have the former without the ladder. But obviously markets are differentiating between the net income, free cash flow generation, and capital return strategies generated by Technology companies relative to energy companies. If that were not the case, then energy companies (which have doubled their returns to shareholders over the past two years prior to the previous two years) wouldn’t be priced at less than the value of one Nvidia or less than half the value of one Microsoft.
Sure, we could debate the factors and forces driving this disparity and to be honest I’m not sure there is a way to support anyone’s argument with 100% certainty, but I’m more confident than I’ve ever been in the view that structural forces perpetuated by passive investing are dominating fundamental factors. That doesn’t mean investors should abandon prudence, discipline, and thought in favor of mindless participation although that would be easier and has proven to be effective. The biggest take away for me over the last couple years as I spent more time researching and understanding this structural change is to respect, monitor, and adapt to it.
You see, the S&P 500 has and with each passing day continues to evolve into a momentum fund. As capital flows into the index, it has to continue to buy more and more of the largest weighted companies. For sure, the MegaCap Tech companies are deserving of a premium relative to most other businesses, but their market cap gains have been aided and abetted by these flow dynamics. We have now reached a point where the Tech sector is worth a third of the total U.S. equity market, topping the previous peak seen in July 2000 at the height of the dot-com bubble.
In a way the equity market is becoming an uroboros (an ancient symbol depicting a serpent/snake or dragon eating its own tail). As long as inflows continue to flow into the equity market more and more capital is forced into the largest names at the expense of smaller names. Have you thought about why small caps are still down 20% from their highs with nominal GDP at all-time highs? Aren’t small cap companies supposed to be the most cyclically sensitive and largest beneficiaries of economic strength?
Let me reiterate that my interest in shedding light on this topic isn’t to pick a side or demonize passive investing. But rather to acknowledge its existence and encourage investors to recognize its potential impact on driving shifts in fundamental relationships that are inconsistent with the past. My job as a steward of other people’s capital isn’t to try to convince the market of my view (it could care less), but rather understand and adapt to the market’s ever evolving view. This structural change poses a significant risk to investors should the dynamics that perpetuate it reverse. Namely 401k flows from the labor market and retirees’ distribution schedules. If the labor market were to reverse and experience job losses those 401k inflows dry up. If retirees have to start invading principle and outright selling assets to fund their retirement lifestyle, this will act as a source of liquidation for stocks and other assets they hold. This is why I think the labor market has become the key economic variable for the economy and financial system.
As for some current market thoughts. I think we’re nearing a point where at least on a short-term basis investors are abandoning discipline and giving into the temptation of joining the herd. The iShares Momentum Factor ETF (MTUM) is nearly 27% above its 200-dma which is about as wide an extension as has been experienced in a decade. Johathan Krinsky, Chief Market Technician at BTIG, put out the following chart on the momentum factor showing that it is approaching similar levels to November 2021 when the Nasdaq and small cap stocks peaked prior to the major correction in 2022.
In a nutshell, I just don’t find the equity market that attractive at the moment. What made equities compelling several months ago has completely flipped since then:
Sentiment is at the upper end of historic readings whether you’re looking at the CNN “Fear-Greed” Index, the Market Vane bullish sentiment indicator, or the AAII bullish percent index. Suffice it to say there are a lot of investors back on the bullish side of the boat. Not to mention a volatility index as measured by the VIX which is trading down to catatonic levels of around 13 – an indication that complacency is setting in.
Valuations are also on the high side with the S&P 500 trading at a 24x P/E multiple on trailing earnings and north of 20x P/E on forward earnings. Granted, earnings have positively surprised in Q4, but have not increased enough to offset the rise in prices.
And positioning whether you’re measuring CTAs, vol-control funds, or institutional funds are nearing their max allowances.
Don’t get me wrong the medium to longer-term outlook sets up decently; the economy looks to be in good shape, inflation is trending in the right direction, and Fed policy is likely to be more of tailwind than a headwind (notwithstanding the lagged impacts of its prior moves), but the short-term outlook is clouded by the factors listed above. One area that continues to look constructive on all time horizons is emerging Asia. Policy makers in China appear to have finally reached the point of panic and are more forcefully enacting policies to backstop their equity markets. As the investment adage goes, “investors stop panicking when policymakers start panicking”. But its not just China investors should be focused on. South Korean exports look as though they have troughed as activity levels pick up. India continues to be a secular beneficiary of China’s woes, favorable demographics, and ‘friend shoring’. Not to mention valuations in emerging markets relative to the S&P 500 are at their lowest levels in over two decades.
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