The US stock market is increasingly being driven by a handful of stocks, while at the same time, it is struggle street for a large number of Nasdaq-listed shares
As concerns begin to mount regarding rampant inflation, the beginning of an interest rate cycle, supply chain issues and the Omicron variant, the fortunes of a wide number of stocks are starting to divert.
On the Nasdaq, unprofitable companies are having to contend with souring investor sentiment, but the well-known tech giants are continuing to do much of the heavy lifting. So just what exactly is unfolding across the market?
A distinct undertone emerged in December when the Nasdaq was circling its all-time highs, which follows an 18-month bull market. While the index may have looked and still does look in good stead, the broader market certainly hasn’t been as positive.
Rather, a careful selection of stocks have been fuelling gains, and they’re not even in the majority. Only slightly more than one-third of Nasdaq companies have been trading above their 200-Day Moving Average (DMA), despite the tech-heavy index sitting at near historical highs.
Further illustrating the point is the data on the breadth of the market’s performance. Goldman Sachs documents this in something it calls the Breadth Index. It noted that while the majority of S&P 500 stocks saw stellar returns during the period between the US election and April 2021, that equation swung sharply thereafter.
The index was at a maximum level of 100 in April before plummeting to just 16 by the end of the year. That points to an extreme level of concentration among the S&P 500 stocks that are gaining ground and moving the broader market.
Another reflection of this comes courtesy of the S&P 500 Equal-Weighted Index, where every stock in the benchmark index represents an equal weight when it comes to moving the gauge. This index returned 25% between the aforementioned November to April period, while the S&P 500 gained 18%. Since then, however, the equal-weighted index has risen just 7%, falling short of the S&P 500’s 12% rise.
So which stocks are driving the market?
According to Goldman Sachs, there are just five stocks that account for more than 50% of gains between April, 2021 and the end of 2021. As you might have guessed, they are all tech stocks, and big-name players at that. The five in question are Apple (AAPL), Microsoft (MSFT), Nvidia (NVDA), Tesla (TSLA) and Alphabet (GOOGL).
At the beginning of 2021 these five goliaths represented 18% of the S&P 500 by market cap. By the end of the year, this had ballooned to 22%. Even if you take away the April cut-off point, the outperformance of these five tech stocks was responsible for 35% of returns for the S&P 500.
The sight of these names is unlikely to shock many, as each has been at the centre of a large shift in technological trends since the beginning of the pandemic. Furthermore, the growth of the top 10 stocks has been increasing for a number of years such that it is at a multi-decade high. However, it is the direct concentration of names now driving the market that represents a bit of a warning sign for the market.
There is an inherent risk in having such a small number of stocks drive action as this can give rise to a cascading effect if those stocks are suddenly sold-off. Furthermore, generally speaking when there is such a discrepancy between where the index is trading relative to a recent high compared with the median stock and its recent high, this ‘narrow breadth’ has been a forward-signal for returns to moderate over the coming months and prompt larger drawdowns by funds and the like.
Over the last forty-odd years there have been 11 instances where the breadth of the market has fallen by as much as that seen in the six months up til October, 2021. On most occasions thereafter, the S&P 500 delivered below-average returns over various time frames spanning up to 12 months later. Historical data tends to suggest leading stocks hold onto their ‘winning’ ways when breadth narrows, but the duration of this narrower breadth takes four months to correct itself, by which time underperforming stocks start to gain traction
Woes for Nasdaq names
For all the success of the leading top five stocks, there is a flip-side to consider as well. And that lies in the stocks that have underperformed over recent months, particularly amid the rotation out of growth stocks in light of the hawkish pivot from the US Federal Reserve.
With the Fed now signalling it is likely to raise interest rates three, or potentially even four times in 2022, Treasury yields have been surging in response to the outlook. And since growth stocks tend to be more susceptible to rising rates, due to the uncertainty in trying to value their future earnings, a wide number of Nasdaq companies have found themselves under pressure.
To illustrate this point, some 40% of Nasdaq-listed companies are currently down by more than 50% from their recent 52-week highs. Under any normal circumstances, were it not for the leading five carrying the market, the depth of this weakness across the broader Nasdaq would be signs of a market rout. Yet here we are, with the tech-heavy index still sitting at a relatively elevated level, even after the recent pull-back.
There have been just a handful of times when there have been more tech stocks slump by such a magnitude in unison. The first of these was when the tech bubble burst back around the start of the century. Following that, the Global Financial Crisis actually saw the highest portion at any given time with nearly 75% of all tech companies down by over 50%. The other instance was when COVID first started spreading across the world in March, 2020, smashing global equities.
Funds are well aware of the stark divide between these two camps of stocks. In fact, hedge funds have been selling many of the underperforming names in mass given lofty valuations and the threat of rising interest rates looming. From a broader perspective, however, the data reinforces the fact that holding anything but the top five names would have made it incredibly difficult to realise a strong result over the last nine months, let alone outperform the market.
As the 10-year Treasury yield sits at a level that is as high as that seen throughout the entirety of 2021, it appears investors are not done with readjusting valuations for vulnerable tech stocks. With that said, given the economic outlook is still in good stead, and rates will still be very low relative historical levels, the backdrop is good for high-margin and high-growth companies with profits to support their valuations, at least while narrower breadth persists. In time the underperformers should have their day in the sun as well.