Andrew Pyle
June 22, 2023
Beware of concentration and high-risk creep
In this week’s conference call, I presented an analogy between the ancient summer solstice ritual of rolling a burning wheel down a hill into a body of water and how the hot US stock market has also hit a bit of a chilly pond in recent sessions (playback details from the call can be found at the end of the newsletter). It’s not that there has suddenly been a sea-change in fundamentals. Quite the contrary. The reality that central banks are going to remain vigilant in their battle with inflation is no different today than it was weeks ago. What is different is that bulls have finally woken up to the fact that said battle offers very little in the way of positive news for stocks as we close the books on the first half of the year.
As I mentioned on the call, it is unlikely that we would see a major reversal in the final trading sessions of June and the gains seen in the second quarter would largely be intact, at least for US and European markets. In terms of the S&P500, Dow and NASDAQ, this will probably be the third consecutive quarterly gain, while the TSX, London FTSE and the Euro Stoxx 50 index could see minor declines this quarter. Sentiment in the US market has remained buoyant, even with the setbacks this week, and we can see this from indicators like the American Association of Individual Investors (AAII) US Investor Sentiment index.
There are two readings that are taken – one measuring bullish sentiment and the other one that reflects on bearish sentiment – and they stem from responses to the question “I feel that the direction of the stock market over the next six months will be“. Analysts and traders will typically use these readings as contrarian indicators, meaning that extremely high measures for the bullish index will signal a potential market top, while large bearish readings will suggest a possible bottom. As you can see from the chart above, the bullish metric reached 45 last week, which was the highest since November 2021. We saw much higher levels in the first half of 2021, but we right now on par with the best readings seen in 2018 and early 2020 – right before we saw significant corrections in the S&P.
A reading above 40 doesn’t necessarily mean the market is in store for a major retracement, but this is still above the long-term average and suggests that investors have been crowding into stocks. That may be because they have missed out on the rally since last October, and I could say the same thing about bond sentiment, given that many investors simply cashed out in favour of low risk/zero growth things like GICs.
Cash levels have come down, at least according to the AAII survey, with respondents indicating a cash allocation of 20% last week, versus a recent high of almost 25% last October. Again, a cash allocation of 20% is hardly an indication that investors are betting the farm on stocks, especially compared to last August and right before the pandemic, when cash allocations were down in the 14%. And we are still almost double the cash allocations seen during the tech mania of the late-1990s. This is partly due to the fact that investors are realizing they can get paid much more for cash today than back in 2018 and 2020. Again, none of this suggests that the US market is about to fall off a cliff, but there are definitely things for investors to be cautious about in addition to simply high valuations relative to monetary policy direction. One of those is the concentration of leadership in the S&P500 and, more importantly, what this might be doing to underlying risk exposure.
By now you have heard that the major driver behind the S&P this year has been technology and how a number of companies in this sector have vaulted in recent months. Let’s consider a few numbers. The NASDAQ 100 is an index containing the top 100 firms in the NASDAQ composite. Currently, the market capitalization of the NASDAQ 100 is about $17 trillion dollars. The top 10 companies in the index have a combined market cap of approximately $11.7 trillion and this represents 68% of the overall index. In fact, 9 of these 10 companies are in the tech space (provided you think of Tesla as a tech versus car company). The 10th largest firm is actually Pepsico Inc.
The only company in the NASDAQ top 10 that doesn’t appear in the S&P500 is ASML Holdings, so let’s look at where the other 9 show up in what is viewed as the benchmark for US equities. With Pepsico, these companies are in the top 25 list of the S&P. Considering that the market cap of the S&P500 is about $38 trillion, these 9 represent 30%. Let’s narrow it down to only those companies with a market cap of a trillion dollars or more – in this case, Apple (market cap $2.89 trillion), Microsoft (market cap $2.48 trillion), Alphabet (market cap $1.54 trillion), Amazon (market cap $1.28 trillion) and NVIDIA (market cap $1.06 trillion). Those 5 alone make up 24% of the S&P500. The chart below compares performance of the S&P500 since the start of the year with an index that I created based on the top 10 companies in the NASDAQ 100. As you can tell, there has been quite a divergence between the 14% gain on the S&P and a 74% move in the top 10 index.
In addition to the risk that this growing concentration has created, we also need to be aware of what this does to the perceived risk associated with investing in something like a passive S&P500 index (fund or ETF). Back in 2021, the Canadian Securities Administrators (CSA) implemented what is known as Client Focused Reforms, or CFR. The reforms are focused on ensuring that a client is always put first and one of the key components of CFR is the regular review and discussion pertaining to risk capacity and risk tolerance – key pillars of “know your client”.
This review is intended to ensure that the appropriate levels of low, medium and high risk securities are maintained in a client’s portfolio. Financial institutions will evaluate securities and assign a risk rating of either low, medium or high, which will then flow up to provide an overall assessment of whether the client’s holdings fit within their individual risk parameters. Risk encompasses many elements, but the one that investors focus on most is the degree of volatility.
Traditionally, we would think of large cap US stocks as being generally medium risk and even though we can find numerous companies in the entire S&P500 that are high risk, their share of the index is small enough that it doesn’t move a security that tracks this index from medium to high. That is not happening today either, but there has been a creep towards high risk based on the concentration. Right now, there are two stocks in the top 10 companies that are rated high risk (Alphabet and Tesla) and one that is rated medium-high risk (NVIDIA). Further down in the 18th spot is Broadcom with a high risk rating.
The surge in valuations in this top tier of stocks has come largely from a euphoria over artificial intelligence, or AI. If we believe that the AI revolution is real and is going to lift all boats, regardless of fundamentals, then maybe we don’t have to worry about things like risk. I personally don’t believe that investors have a firm grasp on where this technology goes and even if over the medium to long term, this is going to be pervasive, there are certain laws of gravity that still apply. For example, where do firms get the capital to invest in this technology when borrowing costs are higher and spending plans get pulled back in the event of a recession?
If anything, the current environment reinforces the need for a more active and tactical approach to portfolio management. We will always need or want exposure to technology, but we have to know where these exposures are and, if they are hidden in off-the-shelf passive baskets, what is it doing to our overall risk levels.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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