Log inThe Emperor’s New Clothes rally in US equities masks weakness under the surface – from Charlie Hancock
The S&P 500, which is the most widely followed equity index consisting of the 500 largest US listed companies, has risen by 12% in the year to date. The rally has prompted a flurry of investors declaring that we are in a new bull market, dismissing concerns about the broader economic environment and the outlook for corporate earnings.
We are not convinced and we believe that the right approach is to remain cautious. We feel that the performance of the overall S&P 500 index paints a misleading picture on the health of the broader stock market.
Most major equity indices, including the S&P 500, are market capitalisation weighted, which means the most valuable constituent companies have a bigger impact on the movement of the overall index, whereas the change in stock prices for the least valuable companies in the index have a much smaller impact. In recent months, we have witnessed a return of speculative buying in some of the largest US tech companies, pushing their stock prices higher. The chart below highlights the gain between 1st January and 1st June for a basket of 7 of the largest US companies, namely Meta (Facebook), Amazon, Apple, Microsoft, Alphabet (Google), Tesla and Nvidia. The rise in these stocks lifted the broader S&P 500 index up by 11%, whilst a market cap weighted basket of the remaining 493 companies in the index remained flat.
We believe this narrow rally, where a small number of companies drive equity indices higher, is unsustainable and points to wider investor concerns which are masked by the overall index level. We would also argue that this is not consistent with the early innings of a bull market, where participation would usually be much stronger and would include smaller companies and cyclically sensitive areas, such as commodities and financials. The current environment would be a strange way to start a new bull market, with the year to date performance for the S&P 500 energy sector and financials sector being -8% and -3.5% respectively.
The speculative behaviour driving gains for some of the technology companies highlighted above is particularly evident in the case of US microchip developer, Nvidia. Amidst a growing interest in artificial intelligence (AI), the company is attempting to capitalise on the hype, predicting significant revenue growth due to demand for their chips in AI applications. The Nvidia board also predicted a similar boom in early 2021 due to the use of their chips in the Cryptocurrency industry, however, this ultimately failed to come to fruition. The recent surge in Nvidia stock appears detached from fundamentals and is not the type of movement you would expect to see during the early stages of a bull market.
Closer to home, the UK’s FTSE 100 index is flat in the year to date, however, this also masks the weakness in many of the index’s constituent companies. Banks, oil companies and housebuilders are all down in the year to date, reflecting concerns about the broader economic outlook.
In summary, we are highly sceptical of the view that we have entered a new bull market and remain defensively positioned in our portfolios, with a focus on capital preservation. The current environment calls for a dynamic approach and so we expect to make further changes to our strategies in the coming weeks and months as the cycle progresses.