S&P 500 vs S&P 5

[윤영준]

Given darkening clouds over the global economic activities, the resilience of the US stock market appears perplexing. There are several signs of a possible recession in advanced economies: inverted yield curve, pessimistic ISM supply manager surveys, weak commodity prices, tightening financial conditions and etc. Nevertheless, the US stock market continues to grind higher and the market volatility (VIX) is missing in action. It is not only the expected volatility but the realized volatility also hits the lowest level since November 2021. Whereas bond investors fret over decelerating economic growth and the health of the US banking system, do equity investors discount the possibility of a recession and presume a better economic scenario? Well, equity investors are responding to the economic uncertainty by buying growth stocks.

The S&P 500 is up 9.3% for the year while Nasdaq Composite has now gained more than 20%. However, the benchmark composition may disguise what is really happening under the surface. In fact, the recent performance of S&P 500 index is mainly driven by the mega-cap technology companies. Since the beginning of 2023, the largest 20 companies have accounted for more than 90% of the total gains of S&P 500. In other words, the overall performance from the rest of S&P 500 companies is more or less flat year to date. Considering the market weight of those large companies, the contribution from not-so-large companies is minimal to the benchmark performance. Top 7 companies in terms of market capitalizations – Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla – constitutes more than 25% of S&P 500 market capitalization, and they have delivered stellar returns so far shown in the Table.

The ranking of top 5 companies in the past reveals that no single companies exert a staying power in the list since 1960. The longest survivor is Exxon Mobil, which ranked within the top 5 until 2016. As the economy evolves and technological innovations take place, the importance of certain industries and dominance of particular companies naturally change. Well-known household names appear in the early period but they had been gradually replaced by technology companies, some of which did not even exist before 1990s.

Some investors are concerned about the concentration of a few large companies in the benchmark. However, it is nothing new. In 1970s, top 5 companies also accounted for more than 20% of the total market capitalization of S&P 500 index. Then, it fell below 15% and remained there until the outbreak of Covid-19. One noticeable difference now is that the current top 5 companies are originated from the same sector, namely, technology-related industry. Previously, national champions from S&P 500 index were represented by various industries, and the benchmark performance was not so entirely dependent on a specific industry as now. This presents some difficulties for investors because the stock market can decouple from the underlying economy and investment returns are highly sensitive to sector and company selection. As shown in the Chart below, the more concentrated the benchmark becomes, the better performance of the cap-weighted index over the equal-weighted index.

Top 5 Companies (% in S&P 500)

Historically, the cap-weighted index tends to perform worse in the long term known as small-cap risk premium because the only way for the biggest companies at any one time is down. For example, IBM, General Electric, AT&T or General Motors are no longer market heavyweights. Generally, a narrow market, in which performance is dominated by a few, is not a healthy one. When the majority of the index constituents perform well, it tends to generate a positive momentum of sustainable bull markets. Therefore, the outperformance of equal-weighted index is a sign of a broad market rally. When the cap-weighted index is outperforming, it’s generally because the market as a whole is doing badly, and the defensive properties of the giants are coming into their own. The big selloffs around the Global Financial Crisis and the Covid lockdowns were accompanied by sharp underperformance for the equal-weighted index as in the previous recessions. It’s currently underperforming just as badly as it did on those occasions, and yet the stock market marches on.

* The shaded area represents recessions.

As has been the case of the whole of this market cycle, interest rates are part of the growth stock story. Growth stocks start to outperform whenever the 10-year Treasury yield falls. However, bond yields have stayed where they were since the middle of January. Therefore, it is not a pure interest rates story. In an economic downturn, it makes a lot of sense to avoid value stocks. Stocks with low valuations tend to have more cyclical business models, more debts and more vulnerable business models than high-valuation growth stocks. Hence, value stocks tend to do well in economic recoveries and poorly in slowdowns and recessions. On the other hand, high quality stocks are supposed to outperform in a downturn, where quality generally refers to companies with high barriers to entry, high return on equity, low leverage, and low earnings volatility. Recently, the growth stocks with positive cash flows increasingly represent the characteristics of high quality stocks. As a result, they are able to offer a defensive haven during the downturn. As a result, we have a very unbalanced market, at least in terms of S&P 500 performance. Almost all the positive returns are coming from the growth/tech companies.

Earnings do not seem to be the catalyst for this year’s stock market rally. It is evidenced by companies’ earnings in Q1, which are down from a year ago. Instead, it may be related to liquidity. After the collapse of Silicon Valley Bank, the Fed offered the Bank Term Funding Program to all banks combined with the expansion of the Fed’s own balance sheet. This coincides with the 7.5% rally from March 13 to April 13. Funding and liquidity, not earnings and fundamentals, are the year-to-date drivers of the S&P 500 rally. In addition, a great risk is still lurking from unsuccessful outcome to the debt ceiling talks around the corner. The low volatility in VIX does not necessarily reflect investors’ sanguine risk appetite but is caused by the lack of demand on call options. The CBOE skew index indicates that investors carry lots of downside protection. When Treasuries offer above 4 per cent, there is no strong reason to invest in risk assets like equities. Investors may hope a soft-landing or the dovish Fed could soon pivot to cut interest rates, but there is much else to fear. As emphasized by several Fed officials, although the hike cycle may take a pause now, interest rate cuts will not be needed until inflation falls significantly. In the absence of a strong earnings rebound in sight, the implied equity risk premium already started to rise in the past two months. All this points out that an immediate boost to equities from an end to monetary tightening will probably have to be postponed.

[좋은세상]

다녀갑니다.