Narrow stock market leadership and AI hype

Published in The Sunday Times on June 11th 2023.

I am a fan of novel financial statistics. A recent one caught my attention; if US company Apple was a country, it would be in the G7. Apple’s market capitalisation (currently $2.8 trillion) easily surpasses Canada’s GDP of c. $2 trillion. We could quibble about the appropriateness of comparing GDP to market capitalisation and qualification for the G7 isn’t based solely on aggregate GDP, but let’s not allow facts to get in the way of a great headline.
 

Microsoft & Apple dominate

To put Apple’s size in perspective, its market capitalisation is larger than an index which includes 2,000 US companies. And Microsoft, at $2.5 trillion, isn’t that far behind. Microsoft and Apple together now account for a record 13.4 per cent of the S&P 500 index — the most ever for the top-two stocks. And index performance is being driven by an incredibly small number of companies, most of which have some connection to generative Artificial Intelligence (AI).

The S&P 500 is up nearly 10 per cent in dollar terms so far in 2023, but there is almost ubiquitous unease around the underlying strength of the rally. A mere six stocks account for the entire gain (according to CNBC).

There are a couple of things to consider here; is market concentration and narrow index performance a bad thing? And, is the herding into anything that is perceived to gain from the hype around generative AI, something to be concerned about? In short; no, not necessarily and yes. 

Is narrow index leadership a bad thing?

According to Bloomberg, the equal weight S&P 500 – which measures the performance of the average stock - is underperforming the market cap weighted index by the widest margin (almost 10%) for a calendar year since its data began in 1990. Strong performance by the biggest companies isn’t unusual, but this appears extreme.

When markets’ rally on narrow breadth, it indicates limited participation and a perceived increased chance that the rally will fade. However, analysis from BMO finds that narrow market breadth in general does not necessarily portend poor returns. In previous periods of narrow market leadership, once outlier returns have ended, the S&P 500 on average rises 6.7% in the subsequent six months. In aggregate, the data on narrow market leadership and subsequent returns are mixed. A market dominated by a small number of stocks feels vulnerable to correction. But the long-term data is unequivocal. 

Long term data on narrow leadership

If we cast our eye over long term market patterns, what we have observed recently is nothing unusual at all. One of the most consistent characteristics of global equity markets is that returns are positively skewed—when graphed, the distribution of returns has a long right tail i.e., a small number of stocks with colossal returns and a majority that fall short of the average. This is logical - a stock can only lose 100%, but has unlimited upside.

Vanguard looked at stock returns for the largest 3,000 stocks in the US. For the 30 years ending in 2017, the median return was 7%, far below the average return of 387%. The index return is driven by a very small number of incredibly strong performers. 

Implications for active managers

If you are an active manager, being judged against a benchmark that includes a significant weighting to a small number of mega caps that are richly valued, it becomes increasingly difficult to outperform unless you underweight them.

According to Credit Suisse AG in New York, the five stocks most underweighted by portfolio managers at the turn of this year were Apple Inc., Microsoft Corp., Tesla Inc., Amazon.com Inc. and Nvidia Corp. That worked well in 2022. But has been excruciating in 2023.

Even though active managers were underweight on average ‘30%’ ago, the pressure to load up on those leading companies becomes intolerable, even despite a belief that they are too expensive. Who would be an active fund manager?

If you are invested in a traditional index fund or ETF, your returns will likely be driven by a handful of stocks. This is simply the way market cap weighting works, for better or worse. For the same reason, if you are invested through an active fund, you need to be confident the manager knows where the outlier gains will come from. Make your choice wisely.

AI hype is reminiscent of the dotcom mania

As regards the hype around generative AI, I find it reminiscent of the mania for all things ‘Internet’ around the turn of this century. I don’t get the same sense of retail investor frenzy today that existed back then. But there are definitely some parallels.

The iconic quote from Scott McNealy, CEO of Sun Microsystems, bears repeating. Referencing the Dotcom years when his stock traded at a lofty revenue multiple, he cautioned “At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate…Do you realize how ridiculous those basic assumptions are? … What were you thinking?”

The current AI-driven stock-du-jour, Nvidia is valued at $990bn and has annual sales of approximately $26bn. In other words, the company is priced at nearly 38 times sales. A valuation multiple that would make even Scott McNealy blanch.

There is no reason why the broader market can’t move forward after a period of such narrow stock leadership. But the hype around AI is extreme. I’ve no doubt it will be game changing. But so was the automobile. And as Warren Buffett periodically reminds us, since the Model-T first rolled off the production lines, there have been about 2,000 car companies in the US. Just three survived. Be careful out there.

Market Data: Calendar year returns: 

Source: Bloomberg. Figures in Euros. Total returns.
 

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on Twitter @gconno1.