Fragile Concentration

The old saying “Never put all your eggs in one basket” is top-of-mind as major U.S. stock indices, like the S&P 500, become more heavily reliant on the performance of just a few large companies (Facebook, Amazon, Apple, Netflix, Google, etc.).
George Washington on Rushmore

Affectionately monikered as “FANG+” stocks, these companies have been taking on a larger proportion of the overall capitalization-weighted indices of which they are a part (meaning the larger a company is, the higher its percentage of weight in the index). Consequently, what happens with these companies’ stock prices has an outsized influence on overall future stock market outcomes. This is just one more datapoint suggesting potential market fragility, along with the ongoing economic damage caused by the global pandemic and extremely high levels of market valuation (by most measures). This fragility was on display at the beginning of September when the technology-stock heavy NASDAQ index had its fastest 10% drop on record (even faster than March of this year). If history is any guide, the heavy influence of a handful of, mostly U.S. technology, stock names on major U.S. market indices suggests the current environment offers an unwise and dangerous setup for investors to trust with their nest eggs.

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Twitter Worthy Executive Summary

The COVID-19 situation appears to be stabilizing, yet stock market risks persist with valuation levels still extreme by most measures and primarily driven by relatively few concentrated stock names. In combination, this represents a fragile and dangerous future market setup.

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The Elephant in the Room: A Quick Note on COVID-19

The COVID-19 pandemic continues to be an ongoing societal and stock market-affecting event. In some good news, at least in the United States, it does appear the latest infection surge is stabilizing or falling in most of the country (see below). One of the primary requirements for states to end economic lockdown is to control their infection rates. While a hopeful sign, the receding infection rate may not be permanent, as we head into the normal fall cold and flu season, and especially as schools and other parts of society reopen.



Source: Allen, M. (September 10, 2020). Axios AM. Axios.

To emphasize the last point of the above paragraph, Europe generally had seen falling COVID-19 infection rates going into the summer and are now suddenly seeing a second wave of infections. Fortunately, like in the United States, this resurgence in Europe has not been nearly as deadly as the first wave earlier in the year, with most experts attributing the improved outcomes to the younger average age of the infected and a better understanding of the virus among healthcare professionals. Regardless, Europe’s second wave reaffirms that COVID-19 could reemerge as a threat to the global economy until such time that a vaccine is readily available.

Source: Oppenheimer, P. (September 7, 2020). 10 Reasons Why This Bull Market Has Further to Run. Goldman Sachs Portfolio Strategy Research.

While there is great hope for a quickly developed vaccine, an effective and safe option could be some time in coming, considering most vaccines take years to develop. Those interested in the latest news on this topic may find The New York Times' COVID-19 Vaccine Tracker an interesting page to follow.

Without an effective and safe vaccine, the world will remain concerned about the potential for new waves of infection and additional negative impacts on societies, economies, and investments. For now, even without a vaccine, many health authorities are focused on managing the spread domestically and, while still inconclusive, the newly infected mortality rate appears to be dropping globally. For markets, these possibilities suggest that the ongoing COVID-19 event may not be as economically disruptive and damaging in the future as it was earlier in the year.

Poor Economics, Strong Government Supports, and the Rise of Concentration Risk

It is no secret at this point that the economy was decimated by the government-ordered shutdowns related to COVID-19, and that unemployment levels skyrocketed as a result. While reopening areas are showing some quick recovery, it is worth noting that the current level of job losses from the peak, even after a sharp bounce from the worst levels, is still well below the worst points seen in past recessions since World War II.

Source: August Employment Report: 1.4 Million Jobs Added, 8.4% Unemployment Rate. (September 4, 2020). Calculated Risk Blog.

More concerning is the fact that lost jobs once thought of as just temporary layoffs are quickly becoming permanently lost jobs.

Source: Sonders, L. (September 8, 2020). Crossroads: Shifting Tides in Stock and Labor Markets. Charles Schwab.

The unemployment situation has been one of the primary drivers of fiscal and monetary support coming out of the federal government and the Federal Reserve Bank, respectively. Your CWM team has been closely following the ongoing events surrounding the various support programs, as they are considered to be strong market and economic drivers.

One prime area of interest is the ongoing congressional debate surrounding the extension of enhanced unemployment benefits provided under the CARES Act passed earlier this year. Those funds were provided to unemployed persons beyond traditional weekly unemployment benefits. Mentioned frequently in CWM market commentary this year, these payments were up to $600 in additional funds above traditional unemployment per week, providing some persons with a greater income than when they were working. This program expired at the beginning of August and has been the source of significant congressional bickering since then.

This benefit was somewhat replaced via a presidential executive order that provided just $300 per week in enhanced unemployment benefits, in which 17 states are currently participating.1 Because of that order, the potential expected risk of falling off the fiscal cliff, when the enhanced unemployment benefit expired at the end of July, has been somewhat averted. For now, disposable personal income is still showing some growth since the end of last year. It is worth noting that $300 per week, on top of regular unemployment benefits, still completely replaces lost income for most displaced workers.



Gundlach, J. (September 8, 2020). Hey Kid, Want Some Candy? Doubleline Funds.

While the above described unemployment payments and other economic support programs were arguably necessary, they have resulted in the worst current U.S. government budget deficit in the last 60+ years, rivaling spending during World War II. This level of deficit spending, even on a national level, cannot go on for long without resulting in higher borrowing costs… unless there is a central bank willing to limit those costs via virtually unlimited purchasing of government debt.

Gundlach, J. (September 8, 2020). Hey Kid, Want Some Candy? Doubleline Funds.

Enter the Federal Reserve Bank of the United States (the Fed) and its monetary policy tools, which in just the first few months of the COVID-19 crisis added as many assets to its balance sheet as it did during multiple years of the 2008 Great Financial Crisis. After rising a bit in the fall of 2019, the balance sheet took off like a rocket once the COVID-19 shutdowns began. The Fed expands its balance sheet by printing U.S. dollars (electronically) and then using those dollars to buy assets like U.S. Treasury bonds to suppress interest rates and thereby limit borrowing costs for the U.S. government. This also lowers borrowing costs for other debt instruments like corporate bonds and mortgages.

Source: Rabouin, D. (August 20, 2020). Axios Markets. Axios.

These fiscal and monetary efforts are intended to generally support the economy and provide economic assistance to those most in need of aid. However, they also tend to result in unintended flow of capital into the stock market, which primarily benefits the wealthier members of society with investable assets and companies with easy access to capital. In the present situation, this flow has benefited a few large companies in particular.

Risk Concentration

Government efforts to support the economy have resulted in a sharp market recovery from the March lows, despite still very poor overall economic data. One likely unintended result of these efforts is that the five largest companies (Facebook, Amazon, Apple, Netflix, and Google) grew significantly faster than everything else so far year-to-date. In fact, if you take out just those five stocks, the overall S&P 500 drops from an early September high of up ~11% to just barely positive.

Source: Kostin, D. (September 2020). US Equity Market Update: Logging in for Back-to-School. Goldman Sachs.

Because of this sharp out-performance to the other index components, those five stocks now make up a larger share of market capitalization than at any point in the last 30 years. Notably, there were larger concentrations in the late 60s and 70s, not shown on the below graphic, back with the “Nifty Fifty” style of stock investment. The decade of the 70s is a period known for its volatile upwards and downwards stock market moves that ended with no real market gain for over ten years. In the below displayed range, we can also see the current level of concentration is well above that which preceded the dotcom bust, a multiyear period of market losses. While high stock concentration of an index is not the cause of poor future market returns, it has been frequently seen prior to investing timeframes with notably weak returns.

Source: Kostin, D. (September 2020). US Equity Market Update: Logging in for Back-to-School. Goldman Sachs.

In the current experience, the high concentration can be justified, as the largest companies also saw virtually no earnings impact from the COVID-19 crisis, which cannot be said for smaller companies.

Source: Cembalest, M. and Erdoes, M. (September 9, 2020). The Needle and the Damage Done. J.P. Morgan Asset Management.

However, those five stocks are more highly valued on a price-to-earning basis (P/E of 31) than any year except the irrational 2000 levels (P/E of 55) and just below the Nifty Fifty of the 1970s (P/E of 36). Even though these companies have decent earnings, the price paid for those earnings is currently very steep on a historic earnings basis. Even great companies can be terrible investments if bought too dearly.

Source: Tousley, J. (August 2020). MVP Markets, Volatility, Politics. Goldman Sachs Asset Management.

To emphasize that last point, when looking at the companies that make up the five largest in the most concentrated periods, it can easily be seen that there are not many repeats (just Microsoft, to be exact). This suggests it is highly unlikely that the top stocks today will also be the top stocks of the future.

Source: Tousley, J. (August 2020). MVP Markets, Volatility, Politics. Goldman Sachs Asset Management.

Price is What You Pay, Value is What You Get

It is virtually a crime to write on investing without quoting Warren Buffett periodically; one of his most famous sayings being, “Price is what you pay, value is what you get,” and prices have never been higher or potential value lower based on the valuation measures your CWM team utilizes. While other factors under consideration have shown some improvement, they are not providing a substantial counterweight to the negative model effect caused by the all-time high valuations.

Source: CWM Data Analytics.

Looking at valuation measures more broadly, six out of eight of some of the most utilized valuation metrics are in their 90th percentile or higher compared to history.

Source: Kostin, D. (September 2020). US Equity Market Update: Logging in for Back-to-School. Goldman Sachs.

At this time, your CWM team remains concerned about these all-time high valuations, especially considering the possibility that they may, at least in part, be built on liquidity driving policy decisions of government or central bank officials that could be changed in an instant. As most CWM clients know, a strong investment philosophy of the team is “Expensive things are dangerous” and it is difficult to find a more expensive market environment than the one we are living through today. Expensive markets do not always crash, but they frequently are followed by a period of very low long-term returns. For now, it is best to take some limited risks to provide some possibility of upside participation but remain defensively postured overall while we await market environments with better future return prospects.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients like yourself and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter.

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P.S. Everyone is yearning for a return to normalcy, especially those with small children returning to school, though that effort will undoubtedly have its unique challenges. May we all have patience with one another while we muddle through a difficult time in our national history.



 

Reference:

Picchi, A. (September 11, 2020). Trump's $300 in Weekly Unemployment Benefits Extended to 6 Weeks. CBS News.

This material is for general informational purposes only and is not intended to be a substitute for specific professional financial, tax or legal advice. Individual circumstances may vary.

Investing involves risks including the potential loss of principal. This commentary contains forward-looking statements and opinions. These opinions may not develop as predicted. It is our goal to help investors by identifying changing market conditions. No strategy can accurately predict all of the changes that may occur in the market. Past performance is no guarantee of future results.

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