In the ever-evolving landscape of the stock market, one startling trend has emerged: an extraordinary concentration of investor wealth in just a handful of stocks. Astonishingly, the top five giants of the S&P 500 now account for a staggering 27% of the entire index. This unprecedented concentration underscores a deeper narrative of market bifurcation, where the titans of artificial intelligence soar to new heights of earnings growth, leaving economically sensitive stocks in their wake. These traditional sectors are feeling the repercussions of monetary policy, grappling with the harsh realities of higher interest rates being maintained for longer periods. As investors navigate these choppy waters, the stark contrast between AI-driven prosperity and the struggles of economically sensitive sectors reveals a market divided like never before. Welcome to the new frontier of investing, where a few colossal entities dominate, and the future of earnings growth is increasingly polarized.
Two options here: 1) economic results worsen, and it pulls down growth with the rest of the market as the same driver of concentration reverses the performance in these highly held names, or 2) economic conditions will improve and earnings will broaden out. Hint: earnings estimates point the way but may or may not account for economic conditions.
This Market Looks Familiar…
There’s a saying many strategists use when comparing different economic and market times. We borrow the Mark Twain-attributed quote and apply it to investing with “history doesn’t repeat itself, but it often rhymes.” There was a time when investors were highly concentrated in one area of the market and valuations soared. It was a bull market like none many have experienced for decades, until now, and experienced technicians and investors see the similarities.
I remember when I first started working in the financial services industry how glamorous it appeared to be a stockbroker, day-trading in the late 1990s. At the time, tech stocks were the flavor of the month, year, and decade due to the wide-spread acceptance and possibilities of the internet. It was a time of major technological breakthroughs with the internet boom, mobile technology and GPS advancements, the proliferation of personal computing, massive investment in online businesses, microprocessor advances from Intel and AMD, wireless communication and the development of Wi-Fi, and the rise of digital media. At that time, you could buy almost any tech stock and make money. Day-trading became a hobby and profession for many. I’ll never forget my best friend Karen’s dad asking me whether I’d be put out of the job 25 years ago. Portfolios became increasingly skewed, with some investors allocating their entire holdings to tech stocks. In hindsight, we recognize this period as a bubble, famously described by then Fed Chair Alan Greenspan as one of “irrational exuberance.” However, from 1992 to 1999, it felt like a once-in-a-lifetime trend.
Fast forward to today, investing in artificial intelligence feels remarkably similar. This emerging field, with its profound economic implications, remains difficult to fully envision in terms of widespread use and monetization given its infancy. However, we do know that it will require powerful data centers, which in turn demand substantial hardware. The earnings growth of semiconductor companies, essential for these data centers, surpasses that of most other sectors, including other technology industries. One can’t fault investors for piling into this industry, and especially its leader, Nvidia, with its control of the AI chip market. Nvidia’s market share is between 70% and 95% with gross margins that blow the other chip companies out of the water, according to an article written by CNBC on June 2, “Nvidia dominates the AI chip market, but there’s more competition than ever”. The question being asked, is it a bubble?
Market Concentration
Something Jim Puplava has talked about numerous times on the Financial Sense Newshour podcast, is the positive feedback loop found in exchange-traded fund (ETF) investing and cap-weighted indices. ETFs created a way to invest in an index and trade it during market hours versus getting the end-of-day pricing in an open-end mutual fund. This created a more accessible way to trade these funds due to their liquidity. Increased accessibility into index investing through ETFs has helped the growth of these tools in the portfolios of investors, which has hit 30% according to a CNBC article using Morningstar’s data – shown below.
Michael Kantrowitz, Chief Investment Strategist at Piper Sandler recently said, if you were to invest $1 into the S&P 500 SPDR fund (SPY), about 27 cents would be allocated to just five companies, as of June 20th. If you invest $1 into the Nasdaq ETF (QQQ), 36 cents goes to the top five stocks. If you invest $1 into the Semiconductor ETF (SMH), 20 cents goes into Nvidia. Wednesday, June 26th, Piper Sandler’s Chief Market Technician, Craig Johnson, stated that the combined market cap of Microsoft, Apple, and Nvidia is 320% the size of the entire Russell 2000 small-cap index. As contributions from 401(k)s and other savings flow into these cap-weighted index funds, the dominance of these five companies is further reinforced, creating a positive feedback loop. The market is now more concentrated, invested in these top five holdings now more than at any other time in recent history. This feedback loop enhances their performance dominance as money flows in, but it also exacerbates the impact when funds are withdrawn. Concentration works well when the market is favorable, but the late-1990s dotcom bust highlighted the importance of diversification, a principle that remains crucial for long-term investors.
Another more technical way of measuring the heard activity of investors is through the CBOE’s Implied Correlation indicator. It measures the correlation between the top 50 stocks in the S&P 500 index. This basically can express how investors feel about diversifying or staying concentrated with their investments. While the math is complicated, the results are plain to see that investors feel little need to diversify their portfolios with the indicator at the lowest levels in its history. The CBOE explains the situation better than I: “positive correlation spikes indicate lower expected diversification benefits, increased systematic risk, and a higher likelihood of experiencing extreme tail events associated with sudden market movements.”
The data only goes back to 2006, so unfortunately, it’s not the best indicator to compare current investment concentration to that of the tech bubble in 2000. The indicator rises in bear markets as investors feel safer diversifying their portfolios. The goal of proper portfolio diversification is to decrease correlations between the components of a portfolio to reduce overall volatility. If you are experiencing large swings in your portfolio week by week, month by month, it could be that you aren’t properly diversified.
AI Dominance
So, who are these top 5 companies in the S&P 500? It changes day to day as of late depending on the price of Nvidia, but currently as of June 25th, it is Microsoft (7.28%), Apple (6.56%), Nvidia (6.35%), Amazon (3.72%), and Meta Platforms (2.39%). These companies are investing 10s of billions into their data centers to build out their accelerated processing for large language models like Chat GPT, Bard, CoPilot, and more. Two weeks ago, Nvidia had topped Microsoft as the most-valued company on the planet based on how many shares it has outstanding times its price, i.e. market-cap, before correcting over a few days back below Apple. Investors place a premium for Nvidia because of its competitive advantage and first-to-market accelerated processing units.
While AI adoption is still in its infancy, investment in technology is expanding and there is a clear arms race building for those who can build out their infrastructure vs their competitors. Meta announced an increase in spending last quarter, expanding to estimates between $35 billion and $40 billion, up from $30 billion and $37 billion. Alphabet spent $12B in the quarter, twice the amount from a year ago. Microsoft spent $14B and said they’ll be spending more. Amazon has said it is committed to spending $148 billion to build and operate its data centers over the next 15 years. That means that the main benefactor of the AI arms race has been in the picks and shovels of the movement, Nvidia and AMD, with Nvidia taking the majority of market share. While AMD has been missing out on the AI rally this year, Piper Sandler called the stock its top large-cap semiconductor pick for the second half of the year after meeting with management this month.
The number of companies mentioning AI on earnings calls continues to rise with an inflection point in 2023. No company wants to be left behind in the AI race. Just look at how many are talking about AI on their earnings calls below and by industry.
The other benefactors are the suppliers to these companies like Taiwan Semiconductor Manufacturer, SK Hynix, and Hon Hai Precision Industry (Foxconn). Broadcom and TikTok parent ByteDance are talking about creating an artificial intelligence processor according to Reuters, which could comply with US restrictions on AI technology allowing for the exportation of these chips. Bank of America recently upgraded their price target on Broadcom because of its AI chip business and acquisition of VMWare. Other investment firms have been upgrading their price targets for Apple as well following its WWDC events a few weeks ago which the company used to announce how it plans to tackle AI. After watching the event, many were probably thinking, “I need to upgrade my phone”, as the AI functionality Apple plans will only be available on recent models. The arms race for big-tech companies to compete in AI adoption is leading to powerful earnings growth for the companies that can supply the hardware. More hardware means more power and thus has the energy sector benefited from the renewed fervor in technology infrastructure.
The race to lead in AI technology is reshaping the landscape of the S&P 500, driving unprecedented investment in infrastructure and creating a rippling effect across various industries. As the top companies like Microsoft, Apple, Nvidia, Amazon, and Meta Platforms pour billions into their technological infrastructure, the demand for advanced hardware continues to surge. Nvidia stands out with its market dominance and innovative processing units, while competitors like AMD are gearing up to capture more market share. This surge in AI investment is not only transforming the tech giants but also benefiting suppliers like Taiwan Semiconductor Manufacturer and Broadcom, and the utilities sector, highlighting the extensive reach and impact of this technological revolution. As companies across sectors strive to integrate AI, the resulting growth and innovation promises to reshape the global economy, ushering in a new era of technological advancement and economic opportunity.
Bifurcation
The most popular word in the research I read daily is the term bifurcation. The fundamental analysts use the term to show the divide between companies that are growing earnings and those that are not. The technical analysts use it to talk about the divergent performance of growth (tech) sectors versus economically sensitive sectors like energy, materials, and industrials. The economic weakness shown by many indicators over the past two months has exacerbated the divide in stock performance between these two areas.
The weak ISM Manufacturing and Non-Manufacturing data for April and May have hit economically sensitive areas hard. The retail sales data two weeks ago didn’t help either with restaurant sales falling – a key discretionary indicator. The housing data hasn’t been good with a decline in housing starts leading to declining residential construction. It appears from the housing start data that a peak may be in for this cycle. New housing sales have declined, and U.S. single-family house inventories are on the rise. These two together may finally contribute to a drop in the median sales price, but there’s no indication of that happening yet.
While earnings have improved for the S&P 500 overall over the past year, there is still room for improvement. Earnings turned positive in the third quarter of 2023. Last year, earnings grew a meager 1% for the S&P 500. Analysts expect earnings to grow 11.3% in 2024 as of June 21st according to FactSet, up from 11.2% at the start of the year. FactSet also sees better growth for 2025 at 14.4%, up from 12.7% at the start of the year. At the sector level, Communication Services and Information Technology are leading the way with year-over-year earnings growth of 21% and 18.8% respectively, according to FactSet, while Materials and Energy are expected to have declining growth of negative 1.8%.
The weakness in economic activity and the subsequent drop in interest rates over the past two months has reasserted the dominance of growth sectors (tech and communications) and weak performance for everybody else. The resulting performance bifurcation is evident in the divergence between growth and value as well as in the difference in size from large companies versus small. Double-digit returns this year have been found only in the large-cap, large-cap growth, and mid-cap growth areas.
Back in late February, I wrote a technical piece titled "Stocks Likely to 'Take Five'," where I highlighted overbought momentum indicators, excessively bullish sentiment priced into options, and the emerging outperformance of value areas. I was a month early. In a bull market, overbought conditions can persist longer than expected. While most stocks experienced a small dip in April, the bullish trend in large-cap tech resumed, driven by Nvidia's strong earnings and falling interest rates. This, coupled with weak economic results impacting economically sensitive sectors, has led to diverging performance in the market. This is shown in the style chart above, but also in the difference between the S&P 500 cap-weighted index versus the equal-weighted index. The difference is just over 10% in two months for year-to-date performance, yet another indication of how concentrated performance is in a handful of stocks in the cap-weighted index.
Market breadth is a measure of how many stocks are participating in the bullish or bearish movement of the market. It is a great indication of overbought (above 70%) and oversold (below 30%) conditions and numerous times has been one of the key flags that tell me about turning points in market trends. This indicator is neutral, showing that the market is neither overbought nor oversold with only half of the stocks in the S&P 500 trading above their respective 50-day moving average.
From a longer-term perspective, there’s the percentage of stocks above their respective 200-day moving average within the S&P 500. This indicator can trend and stay in overbought and oversold areas for longer periods of time compared to the shorter 50-day moving average. So, when the percentage drops below 70% or rises above 30%, this can be a key indication of a possible market inflection point. As you can see in the chart below, it’s been flirting on the cusp of a sell signal with a break below the 70% level, but what’s important is to see that a peak may be in for market participation as of the April top as 15% of the S&P 500 companies have fallen below their 200-day moving average, an indication that not all companies are participating in the May and June rally.
Craig Johnson, Chief Market Technician at Piper Sandler and a frequent guest on our podcast laid out his view last Wednesday morning for the “engine warning lights” he sees in the current market. Many of his comparisons were made between 2000 and now, when investors were just as concentrated in technology stocks. Craig’s price target for the S&P 500 this year remains at 5050. His key takeaways are the following:
- Poor market breadth not confirming strength in the market
- Momentum waning for the S&P 500
- Dow Theory not confirming with the Transport index 15% below the Industrial Average.
- Advance/Decline lines are rolling over
- Prolonged Yield Curve Inversion – the longest in four decades
- Semiconductor stocks are extended
- Defensive stocks appearing on new high list
- Technology weighting near extremes
The weakness in market breadth undermines the current advance. It begs the question what will happen if weak economic data gets much worse? Or…what will need to happen for economic growth to broaden out and subsequently how that affects earnings?
Two Outcomes
I see two outcomes in the months ahead: 1) economic results worsen, and it pulls down growth stocks with the rest of the market as the same driver of concentration reverses the performance in these highly held names, or 2) economic conditions will improve and earnings will broaden out to help increase participation in this bull market from the select few to the many.
There was a silver lining in the economic data this month. PMI by S&P Global released their flash PMI data two weeks ago and it showed that U.S. business activity growth accelerated to its fastest pace in 26 months in June to help finish strong in the second quarter. Headline manufacturing improved 0.4 points to 51.7% with new orders up 0.8, to 51.1% - a leading component of the survey. Services also moved higher by 0.3 points to 55.1%. Both results beat estimates and lead to some confidence that the ISM numbers for the full month will show some improvement when released in early July.
Other components in the reports showed strength. Employment moved higher for both services and manufacturing. Optimism about output in the year ahead moved higher. Selling price inflation cooled to a five-month low in June, though still above pre-pandemic averages. Input price inflation also slowed though manufacturers reported higher raw material costs mainly related to shipping and delivery times lengthening. If these are hinting at supply-chain pressures, it could lead towards higher costs down the road. Chris Williamson, the Chief Business Economist at S&P Global Market Intelligence said, “the PMI is running at a level broadly consistent with the economy growing at an annualized rate of just under 2.5%”. The data was helpful in causing a rally in materials, energy, and industrial sectors. It’s my opinion that the recent economic weakness has hit these sectors hard over the past two months.
Further economic weakness would confirm the April and May trend and could lead towards a recession. There is a lot wrong with the current economy with the consumer being squeezed by higher prices, housing weakness due to high rates, and the excess savings created during Covid being drawn down. The Fed’s higher for longer helps to maintain the current credit restrictions we see in the banking industry. While it appears as if there’s a “new normal” for technology with its strength in earnings, semiconductors are a cyclical industry. If you listened closely to their earnings announcements last season, you will have noted their continued concerns over demand for semiconductors in cellphones and autos. Kelley Blue Book reported a 7.3% decrease in electric vehicles sold in the first quarter compared to the previous quarter. Following the economic conditions over the months ahead will be key in identifying whether the April and May weakness continues to weaken, or whether this was just a dip with the recent flash PMIs for June showing some hope.
If economic conditions improve, as seen in the flash PMIs for June, it’s possible to see the economically sensitive areas improve in performance and a broadening out of performance in other sectors besides technology. Earnings analysts are predicting a return to growth for many of these sectors by 2025 with health care and materials among their top sectors for earnings growth. FactSet shows below that analysts see 19.5% growth for information technology, 18.5% growth in health care, 16.3% growth in materials, and 15.6% growth for consumer discretionary. Earnings are key to driving performance.
Conclusion
In conclusion, the current landscape of the stock market is characterized by a significant polarization, with a handful of tech giants dominating the performance and concentration of the market cap weighted S&P 500. This concentration reflects a broader market bifurcation, where the prosperity driven by AI advancements starkly contrasts with the struggles of economically sensitive sectors impacted by prolonged high interest rates and a consumer still under inflationary pressure.
As we navigate this new frontier, investors face a crucial dilemma: whether economic conditions will deteriorate, pulling down the growth of these leading stocks, or improve, leading to more widespread earnings growth across various sectors. History suggests that market trends often rhyme with the past, and the current scenario mirrors the late-1990s tech boom. However, the enduring lesson is the importance of diversification to mitigate risks associated with market concentration. As AI continues to drive investments and reshape industries, the future of earnings growth and market stability will hinge on broader economic conditions and the ability of other sectors to catch up with the tech-driven momentum. Whether the market will see a broadening of performance or remain dominated by a few key players will be a critical theme to watch in the months ahead, and I don’t anticipate the current theme of polarization will last long as markets tend to feel a gravitational pull towards harmony.
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