11 June 2023

A Tale of Two Markets

By Matthew McKee, CFA, CFP®

June 11, 2023

At first glance, the stock market is doing well this year. The S&P 1500 – a representation of most of the stocks in the US – was up 8.7% through May.

However, looking under the hood tells a different story. There’s a tale of two markets: several large-cap tech stocks, and pretty much everything else.

The S&P 1500 is comprised of the S&P 500 (large companies), S&P 400 (mid-sized companies), and the S&P 600 (small companies). Large-cap stocks are up 9.5%, mid-caps are essentially flat, and small-caps are down -1.4%.

Editorial note: Sometimes timing is everything. We began drafting our thoughts in early June. Since then, smaller company stocks have rallied 7%, underscoring the benefit of diversification.

Within the S&P 500, the difference is even more startling. Out of the 11 sectors, only three – Information Technology (+34%), Communication Services (+31.3%), and Consumer Discretionary (+17.5%) – are up meaningfully.

Industrials are up 1% and the remaining seven sectors are down.

It’s not just a secular story. Large-cap communication services stocks are up 32%, but mid-cap comm services stocks are down -7.3%. Within Communication Services, most of the returns are from the “interactive media services” industry – think META and GOOG.

This is a story of 8 stocks. The market breadth is so narrow that the largest 8 companies accounted for 9.8% of the return for the S&P 500. This means the other 492 had an aggregate loss for the period.

And it is not necessarily that these businesses are improving. Mike Wilson, CIO at Morgan Stanley, noted in a recent Bloomberg interview that these price movements are almost completely driven by multiple expansions. Said another way, these companies aren’t earning more, investors are just paying more for the earnings.

The largest of the eight, Apple, is up ~38% so far this year. However, consensus analyst expectations for both 2023 and 2024 earnings have been revised lower over the last six months, down 4% and 3%, respectively. In fact, sell-side earnings estimates for the entire S&P 500 have been revised down consistently over the last year.

Our view at the outset of the year was that 2022 was a year of interest rate-induced price change and 2023 would see the lag effects of monetary policy changes on earnings – the so-called other shoe to drop. So, earnings estimates are dropping, yet markets are higher.

So why is tech having such a strong performance?

There are a few possible explanations. Some of this could be industry hype (e.g. AI-driven boom in semiconductors) or stock-specific improvements in fundamentals (e.g. META).

It could also be a dynamic reminiscent of the pandemic playbook. Investor fear of a recession causing a “flight to safety” into large-cap tech. The reasoning is that the Fed will cut rates, meaning a lower discount rate and a benefit to growth stocks like tech, where a disproportionate share of earnings is far into the future. The resolution of the debt ceiling and potential for a Fed pause are likely contributors to YTD performance.

Or it could be the historically high level of retail money flowing into stocks. As hobbyist investors put money to work, they “buy what they know” and not necessarily what is trading at an attractive valuation.

Adding to concerns over narrow market breadth in tech, recent economic data has raised the prospect of further Fed tightening. The CME FedWatch tool now puts the probability of another hike at 35.6% (as of June 7), up from 8.5% a month ago. These technology stocks are typically most sensitive to interest rate hikes.

What does this all mean?

While we are long-term optimists for the stock market, we are allocated to higher-quality companies within tech and slightly underweight the sector versus the benchmark. Mid and small-cap companies are trading at much more attractive valuations, and as such, we see a better long-term risk/reward dynamic.

If economic conditions improve and the froth in large tech spills over to other sectors and market caps, our portfolios will benefit. And if there is an interest rate- or earnings- (or both) induced pullback, we will be better positioned.

The main point is that diversification works, even when it appears not to.

As we’ve discussed much in prior newsletters, if you have concentrated positions, whether from employer compensation or otherwise, particularly in large-cap technology stocks, it might be a prudent time to review.

As always, please reach out if you’d like to discuss your portfolio in more detail.