Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
Bad “Market” Behavior Makes for Bad Investor Behavior
We typically do not use the “Hard Assets Insights” space to comment on broader market developments. However, coming into earnings season, we see some important dynamics that are too potentially impactful to ignore.
As we enter earnings season, “the market” makes new highs seemingly every day. The reader will note that we have put the words “the market” in quotes, and we believe for good reason. The historic move from active funds to passive management has had some serious side effects in terms of underlying market composition. The S&P 500 Index is a capitalization-weighted index, meaning that the components of the index are weighted to their total market value, or market cap. The meteoric rise in big tech over the last several months has driven increasing “market” concentration in these names. In fact, the top five tech names in the S&P 500 Index constitute 17 percent of the entire index, and constitute almost half of the year-to-date “market” performance. Just one of those tech companies had a market cap increase in excess of the smallest 300 S&P 500 companies. We also saw another statistic this week that indicated that one of those five companies was as large as the entire S&P 500 energy sector.
Active managers, of course, are almost forced to chase these to full allocations. If they fail to do so, they are underweight relative to their benchmark and likely to underperform. That is a decidedly unpalatable outcome for their bonuses. Buying and holding these stocks has been the safest bet around, if your definition of safety is leaving your chips on the table at the casino. It can make adhering to any value-oriented investment strategy on the part of the professional or retail investor a very difficult relative-performance endeavor.
So what, you are wondering, does this have to do with earnings season? With somewhat detached fascination, we are watching the parabolic moves in many of the “FAANG” stocks – FAANG being an acronym for the big tech names. It feels somewhat like the late 1990s tech bubble to us on some levels, although at least we can say today that there is multiple expansion to be had (versus the late 1990s, when many companies did not even have earnings on which to place a multiple). As the stock prices rise, sell-side analysts are having to either raise their price targets and estimates on these companies or downgrade. Of course, a high-profile downgrade in the face of an ever-rising stock is a sure recipe for an impaired career. While there is certainly earnings growth, the multiple expansion has been nothing short of breathtaking. Suffice it to say, we are going very cautiously into this quarter’s earnings season.
As valuations expand, investor expectations grow ever higher and there can be absolutely no room for a disappointment. Given how concentrated these stocks are within the index, just one or two of these companies falling short of very lofty expectations could create a sell-off for the entire market. This is because so much of “the market” are these stocks that are priced way above historic multiples and effectively to perfection. Central bank liquidity infusions aside, this is not a recipe for the kind of stock market performance we have seen over the last year. This is the kind of phenomenon that typically signals a very late bull market due for some sort of corrective phase or, at a minimum, allowing a breather for the stocks to grow their way into their valuations (giving the “E” in the Price/Earnings equation time to catch up with the “P”).
Thank you as always for your continued interest and support.
Chief Executive Officer