Dear Clients and Friends,
A few weeks ago, we briefly wrote about the stock market’s seemingly irrational recovery and explored some of the logic behind the market’s movements. We discussed a pivot in consumption from smaller, privately held companies and shops to publicly traded mega-corporations; this change may be bad for the overall economy, but good for the stock market (or, at least, good for some stocks). That’s what I want to focus on this week: the idea that the market’s momentum is being supported more and more by fewer and fewer companies.
When we use the term “stock market,” we are often referring to major market indexes such as the Dow Jones Industrial Average or the S&P 500. So, let’s look under the hood of the S&P 500 to reveal some interesting, but scary, realities. For disclosure we are using quite a bit of research from Brian Price, who is a colleague of ours. However, we are reframing much of his reporting and making it applicable to our clientele. Let’s start by looking at the last decade and a half of the S&P 500 and its performance attribution.
The narrow “breadth” of the market is illustrated in the chart below. It shows a record number of index constituents underperforming the S&P 500 by more than 10%, along with a record low 22 percent of stocks outperforming the index. Because of this phenomenon, size-weighted indexes like the S&P 500 have become less and less useful in judging broad market breadth over time.
Source: The Daily Shot, Wall Street Journal
Perhaps the worst-kept secret of what has been driving the market this year is the fact that the technology sector—along with consumer bellwether Amazon (AMZN)—has been on a tear. The magnitude of this drive may surprise some investors, especially when they learn that Microsoft’s (MSFT) market cap is approaching that of the U.K.’s entire FTSE 100 Index or that the Nasdaq market cap is now exceeding the GDP of the entire EU.
To drive home the point of just how strong the momentum has been with the tech-heavy Nasdaq index as of late, just take a look at the chart below. Moving averages are a great gauge of relative strength. We are approaching levels today that were last seen during the dot-com bubble at the turn of the century.
Will History Repeat Itself
The period after the dot-com bubble (2000–2002) was certainly not kind to investors in the Nasdaq, but there are notable differences today that could result in history not necessarily repeating itself. Many of the internet and tech stocks that garnered such a frenzy in the late 1990s had very little or negative earnings, and valuations were beyond extreme. Growth at a reasonable price was replaced with growth at any price, as retail investors piled into anything with “.com” in its company name.
Stocks like Apple, Microsoft, and Amazon are all typically labeled as growth stocks, just as internet stocks were in the 1990s. But these companies are also continuing to deliver solid earnings reports on a quarterly basis. Time will tell if those growth rates will justify what investors are willing to pay for their shares today, but the signs of valuation excess do not appear as rampant today as they were 20 years ago.
It is important to note, however, that the bar has been set higher for these Nasdaq darlings given their recent period of strength. The infamous FANG stocks (i.e., Facebook, Amazon, Netflix, Google) have delivered outsized returns since they all started trading. But it might be reasonable to believe that their magnitude of outperformance may be difficult to sustain in perpetuity. Any sustained rotation into cyclically oriented value stocks could result in a reversion to the mean for some of these Nasdaq highfliers, and future returns may be disappointing for those who have recently purchased exchange-traded funds (ETFs) that track the index.
Concentration Matters
The significant rally in the top holdings in the Nasdaq 100 Index also has implications for broader indices like the S&P 500. Currently, the top three stocks in the widely followed S&P 500 are Microsoft, Apple, and Amazon, with an aggregate weighting of approximately 16 percent. Add in the rest of the top 10 index holdings, and the total weighting of these constituents is more than 26 percent of the entire S&P 500. This is a level of concentration not seen since the dot-com bubble in 2000. Gulp!
At MORWM, we use a combination of individual stocks, actively managed mutual funds, passively managed ETFs, and other index funds. All of these options have advantages and disadvantages that are dependant on a client’s goals, risk tolerance, and portfolio size. However, investors in index products should be mindful of the index’s sector and security weightings. Many of these products are somewhat top-heavy as of this writing, which introduces concentration risk. This is a result of the market’s narrow breadth and the significant share price appreciation of top holdings in indices like the S&P 500.
How does this relate to your portfolio?
In general, markets follow cyclical patterns, and the duration of these cycles vary over time. Growth stocks, specifically the information technology sector and consumer companies like Amazon, have had a prolonged period of strong performance. The trend is our friend for now, but we remain cautious of our exposures and continue to remain diversified in the event that the current cycle turns.
When the markets show signs of weakness, uncertainly, or fear, a traditional investor would divest of highly appreciated growth investments and seek shelter in old school, more conventional value-oriented investments. These value-oriented investments tend to have less growth potential, higher dividends, and lower volatility. However, this is not at all how we de-risked a few months ago. You could say we went fully against the grain.
For moderate and conservative clients, we reduced our stock market exposure by dramatically decreasing our interest in value-oriented companies. For speculative and aggressive clients, we maintained our exposure to the market, but shifted most of it into growth. We did this because it became apparent that new-school companies were more likely to benefit from the COVID-related shutdown; at least, it seemed like they would not be harmed as much as the more traditional sectors of industrials and travel. We’ve gone virtual everything from business meetings to social hangouts to grocery shopping. While this was a good move in hindsight, it has aggravated our time-tested philosophy of broad diversification.
In conclusion: there are some reasons behind the market’s current high level. We’ve commented in other articles about apparent complacency with respect to the unemployment rate exceeding 10%. We’ve discussed how revenue is shifting from private markets to the public stock market. In this article, we shed light on the reality that the health of the stock market may not be representative of the broader economic health of main street America. For better or worse, it is yet another metric that we study in our endless pursuit of financial truth.
We wish everyone a wonderful weekend,
the MORWM team
Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC
1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 |
601 21st Street, Suite 300
Vero Beach, FL 32960
P: 772-453-2810
matthew.ramer@morwm.com | www.morwm.com
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